KATARZYNA CZUPA
Arab money usually connotes three following things: petrodollars, which are invested in artificial islands and ridiculously high skyscrapers; taking over the Western companies, football teams etc.; and financing terroristic groups such as Islamic State. Yet very few people know that it is also invested in one of the most rapidly developing sector, namely Islamic finance.
Towards sharia compliant banking
Modern finance entered the Islamic world alongside the Western colonial expansion. Foreign banks financed trade and development. Since 1840 the Ottoman Empire had been issuing interest-bearing Treasury Bonds, but it is in Egypt where foreign bankers played a truly significant role, as it was the first Islamic country that possessed indigenously controlled banks. The National Bank of Egypt was set up in 1898 and has mixed capital. All institutions established at that time operated in line with the traditional, European model, which involved interest rates and did not comprise any restrictions in terms of the character of the activities.
Gaining independence in the 1950s and 1960s, the Arab states came to reassess their economic policies, also in the field of finance. The concept of a system that would comply with the religious precepts and, at the same time, be viable in a modern economy grew in popularity. Islamic banking was considered an important mode of getting control over the political and economic destiny of the Muslim world. But it was not until some political and economic factors occurred, more specifically the advent of pan-Islamism and the rise in oil prices, that such ideas were put into practice. The fourfold rise in the price of resources at the beginning of 1970s provided the Gulf countries with extra revenues (the so-called petrodollars). This money was supposed to be used to fund development of the region by funnelling it through a brand-new system of financial institutions.
In 1974, during the summit of the Organization of the Islamic Conference in Lahore, the Islamic Development Bank (ISD) was created. Its purpose is ‘to foster economic development and social progress of the member countries and Muslim communities individually as well as jointly in accordance with the principles of Sharia law’. The functions of the Bank are to participate in equity capital and grant loans for productive projects and enterprises besides providing financial assistance to member countries in other forms for economic and social development. It is also required to establish and operate special funds for specific purposes including a fund for assistance to Muslim communities in non-member countries, in addition to setting up trust funds. The institution has become a foundation of the Islamic banking system.
Shortly after the creation of the IDB some commercial Islamic banks were set up. The Dubai Islamic Bank, established in 1975, is deemed to be the first of them. In the following years plenty of similar banks emerged in the Middle East. The Kuwait Finance House (1977), Bahrain Islamic Bank (1978) and Qatar Islamic Bank (1982) are those created in the Gulf Cooperation Council region. Saudi Arabia and Oman remained surprisingly unenthusiastic about Islamic finance. The Saudi authorities were reluctant to provide the Al Rajhi Bank, today the world’s largest listed Islamic bank, with a banking license, as they fret that this might increase the interest transactions of the conventional banks in the kingdom. The Al Rajhi Bank was finally given a banking license in 1987, largely due to the fact that it already had significant deposits, and it was felt that it would be preferable to have it regulated. Oman for political reasons (the incumbents were concerned with limiting the influence of the Ibadi sect) refused to award licenses to any Islamic banking. It was not until May 2011 that this country decided to permit Islamic banking.
Some legislation facilitating the operations of these institutions has been adopted in the recent years. For instance in Kuwait, which in 2004 passed an amendment to the Central Bank Law 32 of 1968, bringing the Kuwait Finance House under the regulatory authority of the Central Bank of Kuwait. This step aimed to ensure that the competition within the Islamic financial sector was open, with other banks allowed to apply for the Islamic banking licenses. Furthermore, in 2011 the International Islamic Benchmark Rate (IIBR), the world’s first Islamic interbank rate, was launched. It was created by Thomson Reuters, the Islamic Development Bank, the Statistical, Economic and Social Research and Training Centre for Islamic Countries and the Accounting and Auditing Organization for Islamic Financial Institutions together with a consortium of the world’s largest Islamic banks. It was a momentous step towards achieving a fully Islamic capital market and decoupling Islamic finance industry from the conventional system. Since the establishment of the first Islamic commercial bank in the mid-70s, the Islamic finance industry has been trying to create an appropriate yardstick that can be used to value a spectrum of the unconventional financial products. IIBR is believed to fill this gap by providing the Islamic financial institutions with a reliable alternative to conventional benchmarks such as the London Interbank Offered Rate (LIBOR). Moreover, the conventional financial institutions have been permitted to open their subsidiaries (they operate in the so-called ‘Islamic windows’) offering customers a choice between the Islamic and conventional products (i.a. HSBC, Citicorp, Goldman Sachs).
The devil is in the interest rate
But what actually differs Islamic finance from the conventional one? The core Sharia principles include: (i) the avoidance of riba (interest in all forms and intents), (ii) the avoidance of preventable uncertainty and ambiguity in contracts, and (iii) ethical principles of justice, fairness, transparency and public interest. These and other principles contained in the Islamic commercial jurisprudence are derived from the Qur’an, Sunnah (sayings of the Prophet), and the legal reasoning by Sharia scholars, and, in their entirety, constitute the foundations of Islamic finance.
Riba is interpreted as an interest, meaning a moderate, economically justified increase in capital, which is paid to the investor after a certain period of time. Some perceive it as a form of usury, claiming that a fixed, predetermined rate tied to maturity and principal impairs the position of the borrower and therefore must be prohibited. The prohibition is based on the arguments of social justice, equality and property rights. Islam encourages the earning of profits, but forbids the charging of interest because profits, determined ex post, symbolize successful entrepreneurship and creation of additional wealth, whereas interest, determined ex ante, is a cost that is accrued irrespective of the outcome of a business operation and many do not create wealth in the event of business losses. As a result, there is no pure debt security as well as Islamic finance products involving interests rates.
Condemnation of surcharging members of the ummah is the basis of another fundamental principle, namely the so-called “profit and loss sharing”. Riba is considered an instrument of transferring risk to those short of money who, being forced to ask for it, are thus in an inferior position. In conventional finance a debtor is the entity bearing the responsibility for failure of the project. The institutions offering capital do not engage in the operations of enterprises and earn only the fixed amount of money determined in the agreement. In Islamic finance, however, the borrower and the lender share rewards as well as losses in an equitable manner. If a company bankrupts, the creditor is also affected, they will not get their money back and have no right to demand any repayment whatsoever. This mechanism is to ensure social welfare, since it prevents financial exploitation and leads to wealth distribution within the society.
The prohibition of gharar, meaning deception, delusion and uncertainty as well as risk and hazard, is the last but not least core rule of Muslim finance. According to the Islamic doctrine, gharar pertains to two situations: highly uncertain conditions and hazard or fraud. On the whole, the term is applied to any form of dealings that involve shazard, benefiting from unjustified profits, deceiving business partners and uncertainty of particular projects. Any gain taken from chance, understood as undetermined causes, is here forbidden. Furthermore, business partners must have equal access to all information since any asymmetry is considered to impair the position of the other party of the transaction. An agreement must be prepared thoroughly and accurately so as not to leave any doubt in terms of interpretation of the particular articles. Moreover, all contracts in the Islamic market must be based on real items. Financing must be linked directly with the underlying asset so that the financing activity is clearly and closely identified with the real sector activity. There are strong linkages between performance of the asset and the return on capital used to finance it. Therefore, the subject of the transaction must be described in great detail determining the quantity, quality, type and price of the product as well as all permissible actions to be taken in case it is destroyed.
The promising venture
According to Ernst & Young Islamic banks have been developing 50 per cent faster than the overall banking sectorand in 2013 value of its assets hit 1.7trillion dollars. This unconventional finance also gained outstanding popularity and significantly increased its market share. In 2011 Sharia complaint assets constituted nearly 36 per cent of total assets in Iran, about 14 per cent in Saudi Arabia, 9 per cent in the UAE, 7 per cent in Kuwait and about 5 per cent in Bahrain and Kuwait (reliable data concerning Oman are not available). The GCC countries are the main centres of Islamic finance, as in total they make for 40 per cent of world Islamic assets. These facts prove that not only we should accept the fact that the Muslim want and will have its own banking sector, but also that we ought to learn more about it. Maybe, given the causes, consequences and even more importantly costs of the global financial crises, we may learn something from it as well.
The article is a part of analysis ‘Islamic Finance. A solution for sustainable economic development of the Gulf Cooperation Council (GCC) countries’ which is to be published within the project ‘Let’s talk about the Islamic finance’.
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Katarzyna Czupa jest ekspertem Centrum Inicjatyw Międzynarodowych ds. Bliskiego Wschodu oraz koordynatorem projektu „Let’s talk about Islamic finance”. Obecnie pracuje jako młodszy analityk w firmie Analizy Online, gdzie zajmuje się analizą rynku funduszy inwestycyjnych. W okresie od kwietnia do listopada 2016 r. pracowała na stanowisku młodszego analityka w Domu Maklerskim Banku Zachodniego WBK, gdzie była odpowiedzialna za analizy rynkowe oraz wycenę spółek. W okresie od stycznia 2014 r. do kwietnia 2016 r. pracowała w CASE – Centrum Analiz Społeczno-Ekonomicznych na stanowisku koordynatora ds. projektów oraz asystenta naukowego. Obecnie realizuje studia doktoranckie w Kolegium Ekonomiczno-Społecznym Szkoły Głównej Handlowej. Jest absolwentką kierunków finanse i rachunkowość (Szkoła Główna Handlowa) oraz stosunki międzynarodowe (Uniwersytet Warszawski). W 2013 roku otrzymała stypendium Ministra Nauki i Szkolnictwa Wyższego za wybitne osiągnięcia naukowe.
