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IslamicFinanceAnOverview
NatalieSchoon
EuropeanBusinessOrganizationLawReview/Volume9/Issue04/December2008,pp621635
DOI:10.1017/S1566752908006216,Publishedonline:17February2009
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NatalieSchoon(2008).IslamicFinanceAnOverview.EuropeanBusinessOrganizationLawReview,9,pp621635
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Abstract
One of the areas of the financial industry that appears to be the least harmed by
the current market turmoil is the Islamic finance industry. Generally, it is
accepted that the history of Islamic finance started in the early 1960s, but is that
really where it all began? This article shows that Islamic finance has a much
longer history than expected and is applying similar principles as debated by the
Greek philosophers as well as early theologians. In addition, the main product
types such as partnership contracts, predictable return products, leasing and
investment certificates are explained.
Key words: Islamic finance, history of finance.
Dr Natalie Schoon, CFA joined Bank of London and The Middle East plc (BLME) in
April 2007 as Head of Product Development. Prior to this, she worked at Barclays Capital as a
senior consultant on the Basel II programme. Dr Schoon has worked at international financial
organisations such as ABN Amro Bank and Gulf International Bank. She began her career in
Islamic finance whilst working in Bahrain, Kuwait and Dubai during the 1990s. She holds a
PhD in financial analysis (thesis subject: residual income models and the valuation of
conventional and Islamic banks) and is an accredited trainer for the Islamic Finance
Qualification.
The views represented in this article are those of the author and do not necessarily represent
those of BLME.
Natalie Schoon
622
1.
EBOR 9 (2008)
Historically, the financial industry has always played an important role in the
economy of every society. Banks mobilise funds from investors and apply them
to investments in trade and business. The history of banking is long and varied,
with periods of frantic activity but also of complete absence of banking.
It all started with the safekeeping of valuables, which, for a long time, was a
task ascribed to religious temples. Valuables in this context predate the invention
of money, and deposits often consisted of grain, cattle and agricultural implements, later followed by precious metals such as gold. There were good reasons
to store valuables in temples:
-
Continuous stream of visitors. This made it difficult for any thief to go about
his business unnoticed.
Strength of the building. Temples tended to be well built, and gaining unauthorised entry was difficult.
Places of worship. The fact that temples were sacred places was deemed to
provide additional protection against potential thieves.
If any one owe a debt for a loan, and a storm prostrates the grain, or the
harvest fail, or the grain does not grow for lack of water; in that year he need
not give his creditor any grain, he washes his debt-tablet in water and pays no
rent for this year.
If any one take money from a merchant, and give the merchant a field tillable
for corn or sesame and order him to plant corn or sesame in the field, and to
harvest the crop; if the cultivator plant corn or sesame in the field, at the harvest the corn or sesame that is in the field shall belong to the owner of the field
and he shall pay corn as rent, for the money he received from the merchant,
and the livelihood of the cultivator shall he give to the merchant.
623
In addition, any compensation for loss of articles in safekeeping, and the amount
of rent to be paid for having the usufruct of land and different species of livestock
was clearly defined.
The Romans were not too keen on lending and deposit taking, and the main
financial activity of the time was to convert any currency into the currency of
Rome, the only legal tender in the city.
The ancient Greek bankers, however, did not just convert currency but also
invested and lent money. In ancient Greece, banking was no longer restricted to
temples but was also conducted by other entities such as traders. Financial
transactions of the time included loans, deposits, exchange of currency and
validation of coins. Financial services were typically offered against payment of a
flat fee or, for investments, against a share of the profit. Trade was financed by
money lenders who would, against a fee, write credit notes that could be cashed
elsewhere in the country, which meant that no coins needed to be carried around
and no guards had to be hired to protect them. Interestingly enough, most of the
early bankers in Greece were foreign residents. Unfortunately, there is little
known about the individual bankers themselves.
Credit-based banking spread in the Mediterranean world from the 4th century
BC. Grain was used as a means of exchange and state granaries in Egypt functioned as banks. When Egypt briefly fell under Greek rule, the government
granaries were transformed into a network of grain banks with a centralised headoffice function, and with the possibility to effect payments by making transfers
between accounts without any physical money changing hands. Although the
Romans subsequently perfected the administrative aspect when they assumed the
rule of Egypt, and introduced enhanced regulations of financial institutions, they
continued to have a preference for cash and, as result, the development of the
banking system itself was limited. With the rising popularity of Christianity,
additional restrictions on the banking system were introduced. For instance, the
charging and paying of interest was deemed to be immoral, and with the fall of
the Roman Empire, banking declined significantly in Europe and did not feature
again until the time of the crusades from the late 11th century AD.
The crusades and the expansion of European trade and commerce resulted in
people travelling to a variety of different countries and in a significant demand for
substantial amounts of physical money that needed to be changed at various
points during the trip. Any service reducing the amount of physical cash to be
carried around and the elaborate precautions against thievery was particularly in
demand. In addition, crusades were expensive and the participants regularly had
to lend money, often by mortgaging land and buildings. However, the terms were
by far more favourable to the lender than to the borrower, as a result of which the
624
Natalie Schoon
EBOR 9 (2008)
demand for mortgages deteriorated over time. International trade led to the
requirement for foreign exchange contracts, the first of which was recorded in
1156, in Genoa.2 The use of these types of contracts expanded significantly, not
only because of the requirements following the development of international
trade, but also since profits from time differences in a foreign exchange contract
were not covered by canon laws against usury.
Financial contracts at this time were largely governed by Christian beliefs
which prohibited interest and applied justness of price and fairness as important
underlying guiding principles to society as a whole. Although, over time, the nointerest principle was abandoned, the evolution to an interest-based banking
system did not happen overnight but was based on a number of factors such as the
change from agrarian to commercial economies, the move towards pricing on the
basis of supply and demand, decentralisation of the Church, and the recognition
of money as a factor of production.3
During the Middle Ages, until the 13th century, the Church was the only entity
possessing significant wealth and was an important lender. However, its impact
declined and as commerce flourished and generated more wealth than could be
reinvested in commerce alone, it was the merchants that lent the money to finance
individual and government consumption.4 Initially only lending their own money,
some merchants became merchant bankers lending both their own capital as well
as capital deposited with them by others.
Whilst in the majority of Europe the Christian prohibition of usury was still in
place, the charging of interest was legalised in Valencia in 1217 and in Florence
in 1403. The legalisation of interest in Florence was more significant for the
development of the banking industry as we know it, since the Florentine bankers,
who already had a presence in a number of European countries, started to offer
loans and deposits on an interest basis.
In the United Kingdom, London was the main centre of trade and hence the
majority of financial transactions were executed there, mainly from the many
coffee houses in the city. In 1565, the Royal Exchange was established in London
to act as a centre of commerce, and some of the banking business moved there
too. However, during the 17th century, stockbrokers were expelled due to their
rather rowdy behaviour, and the buying and selling of stocks was again solely
executed from the coffee houses.
In the early part of the 17th century, Amsterdam started to grow into a major
trade hub, which in turn resulted in it becoming the financial centre of the world
a position which it managed to maintain until the Industrial Revolution in the late
2 Two merchant brothers borrowed 115 Genoese pounds to reimburse the banks agents in
Constantinople by paying them 460 bezants one month after their arrival in Constantinople.
3 J. DiVanna, A Cloud Is a Promise, Fulfilment is Rain, NewHorizon, January-March 2008.
4 B. Supple, The Nature of Enterprise, in E. Rich and C. Wilson, eds., The Economic
Organization of Early Modern Europe (Cambridge, Cambridge University Press 1977).
625
18th/early 19th century and was home to the first ever recorded economic
bubble, Tulip Mania. The tulip was first brought to Holland in 1593 from the
Ottoman Empire, and became so popular that in 1623 a single tulip bulb could
fetch as much as 1,000 florins, which was equivalent to 6.7 times the average
annual income. By 1636, the price had risen to magnificent heights which could
no longer be sustained. Eventually, the bubble burst in 1637 as a result of an
absence of buyers and abundance of sellers.
The Industrial Revolution put America and the UK firmly on the map of international finance. With this shift of emphasis, the banks in these countries
gradually gained importance. London and New York became the major financial
hubs, later joined by Hong Kong, Tokyo and Singapore. The main financial centre
in the Middle East had long been Lebanon, until the war broke out in 1982 and
banks started to move towards Bahrain and subsequently Dubai. Increasing
internationalisation was often achieved by a combination of the establishment of
new branches and acquisitions. In addition, banks started to offer financial
services across the whole spectrum from retail to wholesale, with the side effect
that the once numerous small banks have now merged into a few large conglomerates offering increasingly complex financial solutions.
2.
ISLAMIC BANKING
Natalie Schoon
626
EBOR 9 (2008)
incorporated into Nasser Social Bank. Around the same time, financial services
based on shariaa were set up in Malaysia to cater for the generally under-banked
Muslim population. The earliest Islamic financial services offered in Malaysia
were savings plans for the pilgrimage (hajj) to Mecca.
In 1975, the Islamic Development Bank (IDB) was established in Jeddah as a
multilateral development bank assisting in mobilising funds for investment in
projects in the member states. In the same year, Dubai Islamic Bank was founded in
the United Arab Emirates, which was the first privately established Islamic bank.
The years since 1975 have seen the establishment of many more banks and the
development of the industry into a multibillion-dollar market. It is no longer just
small banks offering Islamic finance. These banks themselves are growing, and
large conventional banks are offering Islamic finance through their Islamic
windows, each with their own advantages:
-
Balance sheet size and structuring capabilities. The large balance sheet size of
conventional banks and their extensive structuring capabilities can be deployed to back large Islamic financial transactions.
Proven track record. Conventional banks have been around for a long time and
have built up a proven track record which generally provides a relatively
higher degree of certainty than a newly established Islamic bank. However,
given the current market turmoil in which banks have announced large losses
and are rescued by their respective governments, a long established bank is no
longer likely to have this advantage over a newly incorporated entity.
Specialised knowledge and expertise. Islamic banks operate completely within
the ethical framework of shariaa and offer skills and expertise in structuring
shariaa-compliant instruments which conventional banks do not necessarily
possess.
5 Top 500 Islamic Financial Institutions, The Banker supplement, November 2008. Even
though only 280 out of 500 institutions provided data, the difference between the total asset
base of the aggregated Islamic banks and the individual balance sheet size of large conventional
banks is staggering.
627
The two types of players are very complementary, and by working closely
together they can achieve high market penetration and work on reaching the full
potential of the market. Fully shariaa-compliant banks and conventional banks
are actively working together to offer Islamic finance, utilising some of the
structuring and distribution capabilities of the large banks, in combination with
the specific expertise which the Islamic banks bring to the table.
3.
ECONOMIC PRINCIPLES
628
Natalie Schoon
EBOR 9 (2008)
economic exchange, money and usury. At the time, economics was not recognised as a science but deemed to be a branch of ethics, which was in turn a branch
of theology. It took until the Reformation and the subsequent separation of
religion and state for economics to become a science in its own right.
-
Money. During the 4th century BC, Aristotle viewed money as a medium of
exchange without an intrinsic value of its own. It was merely a human social
invention which had no utility in itself.
Usury. Following on from the fact that money is a means of exchange and not
a store of value, it was fairly easy to argue that a lender of money loses nothing of worth when lending it out. Christianity does not contain an
unambiguous basis for the ban on usury, although theologians in the early
centuries AD argued that the ban on usury was absolute and without exception.6 The debate on the value of money and usury preoccupied philosophers
and theologians over the ages, and lending at interest has been prohibited to
clerics since the 4th century AD. The ban on usury was extended to the general public in the 12th century. The ban on interest did not end debt finance, it
simply made it more complicated and resulted in the application of different
structures with the same economic effect.
The ban on usury was lifted by the middle of the 17th century, mainly due to
the change of society away from being largely agricultural, the growth of international trade and the increasing separation between state and religion.
Private property. Within the Abrahamic faiths, property is typically deemed to
be owned by God with man having stewardship and should be made available for public use. Although to date the same view is held by Islamic
scholars, the Christian Church turned against it in the early 5th century AD
and began to accumulate significant amounts of property. A large number of
theologians believed that private property had positive effects in stimulating
economic activity and hence general welfare. Purely seeking profit for the
sake of it was, however, still considered to be a serious sin.
Justice in economic exchange. Justice in economic exchange concerns
questions such as whether it is appropriate to make a profit purely from a differential in price, and when this differential is unreasonable. Making a profit
has always been acceptable as long as the entrepreneur is not motivated by
pure gain and the profit (only just) covers the cost of his labour. Aristotle advocated that a just exchange ratio of goods would be where the ratio (or
price) would be in proportion to the intrinsic worth of each of the goods in the
transaction. The Romans, on the other hand, considered demand and supply
6 This argument is based on quite a number of different verses, among which Upon a
stranger thou mayest lend upon usury, but unto thy brother thou shalt not lend upon usury
(Deuteronomy 23:20).
629
to be factors in the determination of price. Their view of a just price was any
price agreed between contracting parties, without any consideration of intrinsic value. During the 12th and 13th centuries, Christian theologians amended
their view on intrinsic worth and came to the conclusion that the intrinsic
value is determined by the usefulness of a good to one of the contracting
parties, hence introducing the notion of demand and supply.
Modern economic theory starts with Adam Smiths An Inquiry into the Nature
and Causes of the Wealth of Nations, in which he builds further on early
economic thought. Smith identifies several factors of production beyond pure
labour, such as land and capital. The shift from largely agricultural societies to a
society focused on trading and production resulted in capital becoming an
important factor of production and having an associated cost.
4.
The rules laid down in shariaa govern every aspect of a Muslims life, including
the way he conducts his business, the criteria for valid contracts and the prohibitions. The law of contract and the prohibitions are as firmly rooted in similar
principles as the old philosophies regarding money, usury, private property and
justice in economic exchange. The rules of a valid contract in shariaa are no
different from contract laws in the Western world. Both trading parties have to
agree on all terms including subject matter, price and delivery, and a contract is
not valid until such time as offer and acceptance match. Shariaa recognises the
same elements of contract such as intention, consideration, certainty of terms,
capability, consent and legality. In addition, there are some further conditions that
apply in shariaa:
-
Value. The subject matter needs to have a value in the eyes of shariaa, which
implies that the subject matter should not be prohibited.7
Ownership. Parties need to have ownership of the subject matter; short-selling
is prohibited.
Ability to deliver. Parties need to be able to deliver the good.
Shariaa, and the prohibitions therein, do not just apply to contracts but govern
every aspect of a Muslims life, including financial dealings. In commerce,
following the ethics of shariaa is considered to be very important. The ethical
framework recognises that capital has a cost associated with it, and is in favour of
wealth generation. However, making money with money is deemed immoral, and
7 Shariaa prohibits conventional banking and insurance, alcohol, pork, gambling, adult
entertainment, tobacco and defence.
630
Natalie Schoon
EBOR 9 (2008)
Unfairness of Riba
For the borrower
Riba or interest creates unfairness for the borrower when the enterprise makes
a profit which is less than the interest payment, turning his profit into a loss.
Consequently, a consistent loss may result in bankruptcy and loss of unemployment while the loan and the interest still have to be paid back.
For the lender
Riba or interest creates unfairness for the lender in high-inflation environments
when the returns are likely to be below the rate of inflation. In addition, unfairness for the lender occurs when the net profit generated by the borrower is
significantly higher than the return on capital provided to the lender.
For the economy
Riba or interest can result in inefficient allocation of available resources in the
economy and may contribute to instability of the system. In an interest-based
economy, capital is directed to the borrower with the highest creditworthiness.
In an environment where profit and loss determine the allocation of capital, the
potential profitability of the project is the guiding principle. When profitability
is the driving factor, even when the creditworthiness of the borrower is lower,
the allocation of capital is potentially more efficient.
631
Gharar An example
Recently, we made an offer on a house that was built in the 1850s. The seller,
who had owned the house for ten years, informed us that there were no structural problems and no damp issues. On inspection, the surveyor found that half
of the beams underpinning the floor were seriously decayed as a result of a
major damp problem which, given the state of the beams, was estimated to
have existed for at least five years. This is a case of gharar since it is reasonable to assume that the seller must have known of this condition, and has
deliberately withheld this information.
My friend Edith, on the other hand, has just bought a house built in the
1960s and asked the seller for information regarding the foundation of the
house. The seller told her that as far as he was aware it was a solid, concrete
foundation. Although there is uncertainty involved, this is deemed to be trivial
gharar and is permissible. Some trust has to exist in this case between buyer
and seller, as the seller is not deliberately withholding any information but is
relaying the information as he knows it.
5.
Natalie Schoon
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EBOR 9 (2008)
individual seeking financing; the bank therefore holds ( part of the) title to the
underlying assets as well, depending on its degree of ownership.
.
6.
Islamic financial products work on the basis that the bank and the customer share
the risk of investments on agreed terms. Profits are distributed based on negotiated terms; risk is distributed based on the share of ownership. In addition,
Islamic financial products typically have an underlying asset or enterprise that
requires financing. The remainder of this article briefly describes some of the
most used instruments in Islamic finance.
6.1
Partnership contracts
6.2
Murabaha contracts are contracts for the deferred sale of goods at cost plus an
agreed profit mark-up under which a party (the seller) purchases goods at cost
price from a supplier and sells the goods to someone else (the buyer) at cost price
plus an agreed mark-up. Murabaha has a variety of applications and is often used
as a financing arrangement for, for instance, receivables and working capital
financing. This type of contract can be used by a supplier to provide deferred
payment terms to a buyer as follows:
1. Sells goods now
Seller
Buyer
2. Pays goods later
633
The buyer knows the sellers original price, the pre-agreed mark-up that he pays
for the deferred delivery and the payment date. Although the seller can charge an
administration fee when payment is delayed, he cannot charge a penalty interest.
A special form of murabaha is the commodity murabaha, which is used for
fixed-term deposits and loans in which the underlying asset is a physical commodity (often an LME base metal). Commodity murabaha is mainly used for
interbank liquidity management and can, in its simplest form, be depicted as
follows:
1. Buys warrants
Islamic bank
3. Pays now
2. Sells
warrants
6. Pays
deferred
4. Sells
warrants
as agent
5. Pays now
Client
Metal broker
Metal broker
Warrants
Cash
6.3
Leasing
Ijara or leasing contracts in Islamic finance are largely comparable with conventional leasing contracts in which the lessee makes periodical rental payments to
the lessor in return for the use of an asset. Both operational lease (ijara) and
finance lease (ijara wa iqtina or lease ending in ownership) are permissible.
6.4
Investment certificate
Sukuk is probably the most well-known instrument in Islamic finance and is most
correctly identified as an investment certificate. Sukuk is often called a bond-type
instrument because it has some similar characteristics. However, unlike the holder
of a conventional bond, a sukuk holder also owns a proportional part of the
underlying asset. Sukuk is not a separate instrument in itself, but is more like a
structure facilitating the funding of large projects which would be beyond the
capability of either an individual or a small group of investors. Sukuk can be listed
Natalie Schoon
634
EBOR 9 (2008)
on recognised exchanges and is, with a few exceptions, generally tradable. In its
most simple, generic form, the sukuk can be depicted as follows:
Corporation
3. Invests
4. Returns
Shariaacompliant
investment
1. Sells
asset
2. Transfers
funds
6. Sells
asset
7. Payment
1. Sells sukuk certificates
2. Payment
Sukuk holders /
investors
5. Coupon payment
SPV
4. Returns
6. Sells asset
7. Payment
The Special Purpose Vehicle (SPV) purchases the asset from the original owner
on behalf of the sukuk holders. The SPV is often set up as part of the group of
companies selling the asset and hence raising the funds. In the interest of the
sukuk holders, it needs to be ensured that the SPV is bankruptcy-remote, which
means that insolvency of the original seller of the asset will not affect the SPV. In
addition, the SPV should not be subject to any negative tax implications and will
need to be established in what is known as a tax-friendly jurisdiction.
Like conventional bonds, sukuk can be bought from the issuer or in the secondary market. Unlike in the conventional bond market, however, sukuk tend to be
held to maturity and the secondary market is not very active. Although quotes are
provided by some market makers, the spreads between bid and asking price are
particularly wide and availability of issues is still thin.
The sukuk holder owns a proportional share of the underlying asset and has a
financial right to the revenues generated by the asset. However, as mentioned
before, the holder is also subject to ownership risk, which means that he is
exposed to any risk associated with the share of the underlying asset that he owns.
Conventional bonds, on the other hand, remain part of the issuers financial
liability.
7.
635
IN BRIEF
The principles underlying Islamic finance have been around a lot longer than the
last 35 years or so. They are based on an ethical framework that not only appeals
to Muslims; its underlying economic and business principles are attractive to nonMuslims as well.
Although interest and gambling are not permitted, there is nothing against
wealth creation and capital is recognised as a factor of production, and hence it is
recognised that there is an associated cost. However, purely making money with
money without any identifiable underlying investment (whether it be an asset or
an enterprise) is frowned upon. Therefore, all product structures in Islamic
finance have an underlying asset and are based on risk and reward sharing
between all parties involved. The Islamic finance market is growing exponentially
and new players are continuously entering the market. Although it is not likely to
replace conventional financing, it is certainly here to stay.
Further reading
DiVanna, Joseph A., Understanding Islamic Banking: The Value Proposition
That Transcends Cultures (Cambridge, Leonardo and Francis Press 2006).
Iqbal, Munawar, and Philip Moyneux, Thirty Years of Islamic Banking History,
Performance and Prospects (New York, Palgrave Macmillan 2005).
Kohn, Meir (unpublished), The Origins of Western Economic Success: Commerce, Finance, and Government in Pre-Industrial Europe, available at http://
www.dartmouth.edu/~mkohn/orgins.html.
Monroe, Arthur E., ed., Early Economic Thought, Selections from Economic
Literature Prior to Adam Smith (Cambridge, Harvard University Press 1948).
Schoon, Natalie, Islamic Banking and Finance (London, Spiramus Press, forthcoming 2008).
Smith, Adam, (1776), An Inquiry into the Nature and Causes of the Wealth of
Nations (complete and unabridged version) (New York, Modern Library
2000).