Benefits of Islamic finance

Modern Islamic finance and its benefits

Although Islamic finance offers numerous benefits, its full potential has yet to be tapped. To truly benefit from Islamic finance, the core of the Islamic financial system must be gradually strengthened alongside a change in mentality from choosing cosmetic changes to ensure minimum Shariah-compliance to a comprehensive adherence to Islamic principles that encourages real trade and commerce while maintaining fairness and justice to all. Below are some of the noted benefits of Islamic finance:

i.                Flexibility

ii.              Resilience

iii.             Stability

iv.             Fair and just

v.              Diversification

vi.             Fulfills religious needs

vii.           Huge market

Flexibility

Islamic finance is simple and straight forward, yet flexible enough to meet the commercial needs of the involved parties. According to Kuwaiti economist, Hajjaj Bukhdur:

Islamic finance already has around 30 different types of products and instruments, giving it a large degree of flexibility to meet investors’ demand and continue to expand rapidly… But it has two major shortcomings: there are different regulatory systems ... and managements have been less competent to realize the full potential.[1]

The recent introduction of Islamic bonds known as sukuks and Islamic derivatives is further indication of the flexibility of Islamic finance.[2] This flexibility allows a variety of different Islamic financial products to be created for a single purpose. However, the level of risk associated with each product and the benefits to the involved parties differ. Currently, many scholars are considering the viability of equity financing compared to debt financing.

The general principle under Islamic law is that everything is permissible and allowed unless it is expressly and clearly prohibited. Therefore, Islamic law is always suitable for implementation because of its flexibility.[3] The problem is that there can be uncertainty regarding the validity of some of the financial products, such as whether they are Shariah-compliant. To avoid this clear hierarchical structure is required. Such uncertainty is eliminated by a clear hierarchical structure at the international level or as reflected in the terms of the contract. If the products are deemed valid by those holding the final say, be it a committee or a respected scholar, there should be no further disputes concerning issues of validity or Shariah-compliance.

Resilience

Islamic finance has often proven more resilient to financial crisis as the result of its guiding principles and because transactions tainted by excessive uncertainty are prohibited. For example, according to Askari et al:

The reason that Islamic financial institutions and capital markets were not directly affected by the subprime financial crisis was that they did not have any exposure to toxic assets (largely debt-based) and therefore, were immune to the crisis during its early stages. However, as the financial crises led to economic recession and global slowdown, the values in the real sector also began to deteriorate, putting pressure on Islamic financial institutions too.[4]

However, Islamic finance is not risk-free. It can, and has suffered loss. According to Islamic finance experts, a business transaction that only guarantees ‘profit’ and rejects any possibility of loss is often usury in disguise. Such transactions are typically not sustainable and tend to involve some element of injustice, eg oppression due to lack of bargaining power or unfair allocation of risks between the parties.

Islamic finance has emerged relatively unscathed from the subprime crisis and the credit default swaps debacle for the following reasons (among others):

Islamic law forbids many of the products and transactions related to those specific aspects of the meltdown-the securitization of debt, the bets inherent to credit default swaps, the excessive leverage, and more generally the sheer complexity and opacity of the derivatives and their distance and disconnection from real assets.[5]

Islamic finance is not immune to the ‘bubble’ dynamic and, indeed, it has started to feel the effects of a different kind of bubble caused primarily by a decrease in asset prices.[6]To truly make the global system more resilient, Islamic financial institutions must depart from the current practice of simply making cosmetic changes because the benefits and add-values expected of Islamic finance cannot be realized in such situations. As long as the attitude and mentality towards risk is similar to that of conventional practices there will be no real benefit. In fact, such an environment might be just as volatile as conventional situations, as reflected by research conducted on the Islamic index.[7]

Stability

There have been numerous works on the stability of Islamic finance, including the work of Askari et al.[8] The recent global recession highlighted the fragility and instability of the modern conventional financial system. To quote Warren Buffett, ‘you only learn who has been swimming naked when the tide goes out, and what we are witnessing at some of our largest financial institutions is an ugly sight.’[9]

According to Dr. Zeti:

Islamic finance has, thus far, remained positive, despite the current challenging global financial environment. The strengths in Islamic finance are derived from the Shariah principles, the key pillar of Islamic finance that has contributed towards its overall stability and resilience. The Shariah injunctions require that the financial transactions be accompanied by an underlying productive activity thus giving rise to a close link between financial and productive flows.[10]

The strength of the largely interest-based conventional financial systems, tainted with occasional excessive speculative activities, has been tested during the recent global recessions and financial crises. Although Islamic finance is flexible in most areas, the fundamentals or core principles remain clear and this result in a more stable system.[11]

Conventional financial systems based on debt can be extremely volatile and their sustainability is questionable, as reflected by the European governmental debt crisis. In 2010, Europe’s Finance Ministers had to approve a rescue package amounting to €750 billion to ensure financial stability in Europe (via the creation of the European Financial Stability Facility). During such financial crises the instability of conventional systems is more apparent. For example, in relation to the European debt crisis, financial speculators and hedge funds engaged in selling the euro, which worsened the crisis, as suggested by Greek and Spanish Prime Ministers.[12]

To achieve better stability, Islamic principles can also be applied to monetary systems. Islamic monetary systems are not against paper money per se. However, they insist on a just system in which stability exists and manipulations and injustice are avoided. Understandably, during the eighth to fourteenth centuries when Muslim empires peaked, gold and silver were the main currency. It would be difficult to achieve the desired stability from modern Islamic finance under current monetary systems. Details on this matter are included in subsequent chapters. Briefly, Islamic finance encourages a stable and fair monetary system that is not easily manipulated. Present-day monetary systems are allegedly tainted by manipulations and uncertainties. It is a well-known fact that countries can currently produce money without any practical limitations and without the backing of a gold reserve. Islamic finance scholars have long claimed that paper money or currency that is not backed by anything, eg gold, can be dangerous.[13]

Fair and just

The concept of profit-loss-sharing, if utilized properly, would lead to an ethically fair and just trade and finance system. According to Zaher and Hasan:

The Islamic community has rationalized the elimination of riba (interest) based upon values of justices, efficiency, stability and growth. In terms of justice, the removal of riba results in the sharing of the risk of a project between the borrower and the lender. In addition, by tying the reward to the performance of the business venture, the resulting returns are more equitable during the good times and bad times.[14]

Islamic finance has the potential to bring a wide range of economic benefits to society through the mobilization of savings, productive investments and general economic development.[15] There is strong evidence that Islamic finance is actually paving the way for a more ethical type of trading and financing. Contrary to the claims made by various writers that Islamic finance is nothing more than cosmetic changes to conventional finance, the facts indicate that some Islamic finance products actually challenge the core of conventional finance (including usury and interest), albeit in a slow and progressive manner.

Some critics argue that Islamic banks use the same rates, such as the London Interbank Offer Rate (LIBOR), to determine their profit, similar to those used by commercial banks[16]. However, Islamic banks have not historically had their own benchmarks for establishing profitability and, as such, have had to use conventional benchmark rates. With the growing demand for Islamic finance, Islamic countries have begun to develop instruments, including Malaysian Islamic Benchmark bonds that allow Islamic banks to have their own benchmarks.[17]

Islamic and conventional finance diverge in the case of default. In conventional finance, the interest continues to compound until the entire principal and interest is paid. However, under Islamic finance, because the transaction is not a loan there is no interest or compounding interest. Therefore, the accusation that Islamic finance is the same as conventional finance is inaccurate.

Conventional debt financing that is collateralized and earns a fixed interest-rate can appear unjust with an unequal distribution of risk.[18] This inequality is even more pronounced when Western governments use public funds to bail out banks, as during the recent global recession. However, Islamic financial systems cannot be introduced by merely eliminating the usury system. It should be done by adapting and fusing the Islamic principles of social justice as an alternative alongside its rules, practices, regulations and instruments to help realize equity and fairness.[19] In other words, a dual system in which the customers and clients can choose the product they prefer should be promoted.

Diversification

Many Western financial institutions are attracted to the diversification offered by Islamic finance, especially with the emergence of new Islamic financial institutions and markets, including international project financing, private equity, the issuance of Islamic bonds (known as sukuk) and various asset, funds and wealth management strategies.[20] This is consistent with the global nature of Islamic finance. 

Product development for Islamic financial services has generally been limited to the reengineering of conventional financial products to meet the formal requirements of Islamic finance. To make a substantive contribution to the development of Islamic finance, a wider view of Shariah-compliance and a new generation of competitive and innovative products will be required.[21]

Fulfills religious needs

Islamic finance enables Muslims to conduct their daily transactions in ways that are Shariah-compliant. The holy Qur'an has talked about the prohibition of riba in many places in chronological order:

In the period of Makkah, Allah (S.W.T.) says in surat Ar-Roum, (Verse 39), what can be translated as, "And that which you give in riba (to others), in order that it may increase (your wealth by expecting to get a better one in return) from other people’s property, has no increase with Allah."

Then, in the period of Al-madinah, interest was explicitly prohibited in the saying of Allah (S.W.T.), in surat Ale-Emran, (Verse 30), what can be translated as, "O you who believe! Do not take riba doubled and multiplied, but fear Allah that you may be successful."

Then, another revelation came down in the saying of Allah (S.W.T.) in surat Al-Baqarah, (Verse 275 & 276), what can be translated as, "Those who deal with riba will not stand (on the day of Resurrection) except like the standing of a person beaten by Shaitan (Satan) leading him to insanity. That is because they say: "Trading is only like riba," whereas Allah has permitted trading and forbidden riba. So whosoever receives an admonition from his Lord and stops dealing with riba shall not be punished for the past: his case if for Allah (to judge); but whoever returns to dealing with riba, such are the dweller of the Fire-they will abide therein. Allah destroys riba and will give increase for Sadaqat (deeds of charity, alms, etc.) and Allah does not like the disbelievers, sinners."

Then, the last thing that was revealed about the prohibition of interest was the saying of Allah (S.W.T.) in surat Al-Baqarah, (Verses 278 & 279), what can be translated as, "O you who believe! Fear Allah and give up what remains (due to you) from riba (from now onward), if you are truly believers. And if you do not do it, then take a notice of war from Allah and His Messenger but if you repent, you shall have your capital sums. Deal not unjustly, and you shall not be dealt with unjustly." This last verse is an emphatic argument that would silence those who say, "interest is not forbidden unless it is a high percentage." But it is clear that Allah did not allow for the person to receive except the exact capital, no more and no less."

Huge market

Moody's Investors Service believes that the full potential is at least US$5 trillion although currently, it only accounts for around 5 percent of the global financial industry.[22] There is a huge market for Islamic finance. The first being Muslims, which compose about 20 percent of the world population. James Hume, executive vice president of the Dubai International Financial Centre, noted:

An increasingly educated populace with growing self-assuredness and awareness of their Islamic roots is becoming alert to the shortcomings of             conventional finance and more vocal in demands for alternatives.[23]

Similarly, according to the Hong Kong Legislative Council Secretariat:

Islamic finance has expanded rapidly in recent years, as evidenced by the growth in Shariah-compliant financial assets worldwide by over 10% per annum during the past decade1. At present, Islamic finance represents a small growing segment of the global finance industry. Measured by Shariah-compliant assets held by financial institutions, the global Islamic finance industry was estimated at US$822 billion (HK$6.4 trillion) in 2009. This figure is projected to reach US$1 trillion (HK$7.8 trillion) in 2010 and US$1.6 trillion (HK$12.4 trillion) by 2012.[24]

In the Middle East alone at least US$1.5 trillion in project financing is expected in the next ten years, and most of it will have strong Islamic financing aspects.[25]

Rehman’s work highlighted the following facts related to high-profile investments made by the Gulf States and Islamic institutions:[26]

• The Gulf States control around 40 percent of the world’s known oil reserves and nearly a quarter of global natural gas reserves.
• By 2006, the foreign assets of the Gulf Cooperation Council (GCC) had already reached US$1.9 trillion.
• The net capital outflows from the Gulf States in 2006 alone were US$200 billion.
• The McKinsey Global Institute estimated that the GCC’s accumulated foreign wealth could reach US$8.3 trillion by 2020.

Islamic finance’s huge market potential is, however, severely limited by Islamophobia. Following the attacks on 11 September 2001, all things Islamic came under a cloud of suspicion, and Islamic finance and Islamic banks were certainly no exception. Discrimination against Muslims increased significantly following the September 11 attacks, with Muslims stereotyped as violent and prone to terrorism without any opportunity to rebut.

There are around 1.3 billion Muslims in the world, and that means that one out of every five or six people on the planet is Muslim. However, the equity and wealth shared by Muslim communities is just around 4 percent and many Muslim countries such as Indonesia, Bangladesh, Afghanistan and Pakistan are largely poor with no media power. Furthermore, almost all of the eminent media is owned and controlled by Western countries with much of it significantly contributing to the negative perceptions and images of Islam that have become so commonplace. A case study of American network news coverage post 9/11 supported the view that objective coverage of Islam is a myth, not just in America, but around the world.[27]

Muslims, especially those from the Middle East, are almost always portrayed as terrorists with the intention to kill the innocent populations of Western countries in Hollywood movies. As a consequence, hatred towards Islam and Islamophobia are on the rise. Mosques in various places have been defaced and burned and Muslims are treated suspiciously, especially those trying to adhere to the Islamic dress code. Requests have also been made by some politicians to refuse citizenship to followers of Islam.

Applications to build non-Islamic places of worship have typically been freely granted, but applications to build mosques have become sensitive and many have been rejected. Therefore, it is not surprising that the negative perceptions towards Islam and strong hatred for Muslims have contributed to the various attacks on Islamic finance, many of which have been based on prejudice and bias. Virtually every work in the abundant ‘secrets of terrorist financing’ literature has alleged that the purpose of Islamic finance is to fund terrorism.[28]

One of the National Security Adviser during Bill Clinton’s second term and the top official in charge of the surveillance of Bin Laden’s networks at the time, alleged that “it would be difficult to track down Osama Bin Laden’s money because it was hidden in ‘underground banking, Islamic banking facilities.”[29] Blanket accusations that Muslims are terrorists, or even violent people, are unwarranted and unjustifiable, but that has not stopped individuals from insisting that Islamic finance should be discouraged because ‘terrorists might use it’.

Conflicting logic plagues these accusations because real terrorists do not want their money to be easily identifiable and would definitely shy away from Islamic finance, which is subjected to a great deal of scrutiny from the authorities. Those involved in terrorism are more likely to receive their funding from other sources including piracy, money-laundering and secret donations and it would be highly counterintuitive to attempt to use Islamic finance for such activities.

Despite this discrimination, in the years following the September 11 attacks, the Islamic finance industry did not crumble and collapse. Instead, it experienced dramatic growth and major transformations while progressively shifting to better products. Criticisms and condemnations of Islamic banks were no doubt a motivating factor in the serious efforts to standardize, rationalize and streamline Islamic finance. Blanket discrimination against Muslims and Muslim countries, particularly those in the Middle East, have also contributed to the development of Islamic finance in certain jurisdictions such as Southeast Asia and particularly Malaysia because some wealthy Muslims and Muslim countries decided to diversify their wealth outside Western countries due to the prevalence of poor treatment and negative perceptions.

Furthermore, the risk that their assets might be unfairly frozen merely because they were Muslims also contributed to the shifting of assets and investments outside Western countries. Islam is one of the most misunderstood religions and its negative portrayal in media and much of society has been detrimental to the development of Islamic finance.

According to the 2009 survey on religious attitudes, a shocking 58 percent of the Americans interviewed agreed that Muslims face more discrimination than any other religious group in the United States.[30]

With a proper strategy for improving the relationships between Muslims and non-Muslims in place and a more efficient use of the media to reduce negative perceptions, it is possible to ensure a brighter future in which kindness and mutual understanding leads the way. Due to the strong and systematic bias and discrimination in the West towards Muslims, especially those from the Middle East, many wealthy investors and Middle-Eastern Muslim countries are looking for alternatives. This has contributed to the growing Islamic finance market outside the United States. Furthermore, non-Muslim investors have also contributed to this expansion with the market for sukuk increasing from close to zero in 2001 to US$100 billion in 2007, in part because non-Islamic investors have acquired a substantial percentage of the sukuk market.[31]

---

[1] Omar Hasan, ‘Islamic finance should diversify, analyst say’ Agence France-Presse (Kuwait 5 September 2010)

<http://www.hurriyetdailynews.com/n.php?n=islamic-finance-should-diversify-analysts-say-2010-09-05> accessed 17 November 2011.

[2]See Asmadi Mohamed Naim, ‘Chapter 9 Shari'a Criteria: Issues in Company Investment and Sukuk issuance in mixed activities’ in Humayon A. Dar and Umar F. Moghul (editors), The Chancellor Guide to the Legal and Shari’a Aspects of Islamic Finance (Harriman House 2010)

[3] Mohd Akram Laldin, Islamic Law: An Introduction (IIUM Press 2009) 40

[4]Hossein Askari, Zamir Iqbal, Noureddine Krichene and Abbas Mirakhor, The Stability of Islamic Finance (John Wiley & Sons (Asia) Pte. Ltd 2010) 199

[5] Ibrahim Warde, ‘The Relevance of Contemporary Islamic Finance’ (2009) Berkeley J. Middle E. & Islamic L., 164.

[6] Ibrahim Warde, ‘The Relevance of Contemporary Islamic Finance’ (2009) Berkeley J. Middle E. & Islamic L., 164.

[7]Amélie Charles, Adrian Pop and Olivier Darné, ‘Is the Islamic Finance Model More Resilient than the Conventional Finance Model? Evidence from Sudden Changes in the Volatility of Dow Jones Indexes’ (International Conference of the French Finance Association (AFFI),11-13 May 2011) <http://ssrn.com/abstract=1836751> accessed 17 November 2011.

[8]Hossein Askari, Zamir Iqbal, Noureddine Krichene and Abbas Mirakhor, The Stability of Islamic Finance: Creating a Resilient Financial Environment for a Secure Future (John Wiley & Sons (Asia) Pte. Ltd 2010).

[9] Francesco Guerrera and Justin Baer, ‘Buffett defends sovereign wealth funds’ Financial Times (29 February 2008).

[10]Zeti Akhtar Aziz, ‘Governor’s Keynote Address: Islamic Finance: A Global Frowth Opportunity Amidst a Challenging Environment’ (State Street Islamic Finance Congress 2008, Boston USA, 6 October 2008).

[11] For example, due to the prohibition of interest, Islamic finance encourages real trade and business activities that generate legitimate income and profit. The prohibition of dealings with transactions tainted by gharar or major uncertainties means that speculative activities and excess leverage are avoided. Islamic finance is generally safe from the uncertainties and fragility created by the gambling-like speculations that occur in conventional finance, particularly in relation to short selling, sales on margin and debt-based securities. Islamic finance keeps the financial sector in sync with real-world sectors, such as trade and commerce by insisting on a stable and fair market. A strong perception exists that the distribution of income and wealth are generally unfair and that inequality is increasing, as reflected by the growing gap between the rich and the poor.

[12] Sean O'Grady, ‘Soros hedge fund bets on demise of the euro’ The Independent (London 2 March 2010) <http://www.independent.co.uk/news/business/news/soros-hedge-fund-bets-on-demise-of-the-euro-1914356.html> accessed 17 November 2011.

[13] During World War II gold holdings peaked at around 20,205 metric tonnes (in the United States alone). The United States still has the largest gold reserve in the world, estimated at 8,133.5 tonnes in 2010. In comparison, China’s gold reserve is estimated to be around 1,054 tonnes. The PRC has also indicated its intention to increase its gold reserve in response to the uncertainty of global monetary systems. An analysis of the gold supply showed that around 160,000 tonnes of gold has been mined from the beginning of recorded history through the end of 2008. Furthermore, the gold demand for jewelers, industrial and central bank reserves equates to approximately 100,000; 30,000 and 30,000 tonnes, respectively. It has been proposed that the world’s gold supply is sufficient to regulate and accommodate global trade and commerce, although the world’s wealth will be more limited because gold cannot be printed like paper money. It is, however, more sustainable. While gold currency, unpegged to paper money, can be effective, gold is not necessarily a good investment. Although Islamic finance is not against fiat money or paper money per se, Islamic financial experts have long voiced that a system in which money can be printed at will and is easily manipulated is vulnerable to injustice and uncertainties. They have proposed that a time will come when fiat money finally loses its value and that the application of Islamic principles to monetary systems, if observed, could provide a cushion at such a time. Islamic finance experts have different views concerning the use of gold and silver (even the gold standard) as a medium of exchange and its relation to stability.

[14]Tarek S. Zaher and M. Kabir Hassan, ‘A Comparative Literature Survey of Islamic Finance and Banking’ (2001) Financial Markets, Institutions and Instruments, V.10, No.4 (November).

[15] Ibrahim Warde, ‘The Relevance of Contemporary Islamic Finance’ (2009) Berkeley J. Middle E. and Islamic L., 166.

[16] Beng Soon Choong and Ming-Hua Liu, ‘Islamic banking: Interest-free or interest based?’ (2009) Pacific Basin Finance Journal, Volume 17, Issue.1 (January) 125-144

[17]Gohar Bilal, ‘Islamic Finance: Alternatives to the Western Model’ (1999) The Fletcher Forum of World Affairs, Vol.23, 158.  

[18]Ataul Huq Pramanik (ed), Islamic Banking: How Far Have We Gone (Malaysia: IIUM Press, 2009) 14.

[19]Sudin Haron and Wan Nursofiza Wan Azmi, Islamic Finance and Banking System: Philosophies, Principles & Practices (McGraw-Hill (Malaysia) Sdn. Bhd, 2009) 97.

[20] For example, see Tarek S. Zaher and M. Kabir Hassan, ‘A Comparative Literature Survey of Islamic Finance and Banking’ (2001) Financial Markets, Institutions and Instruments, V.10, No.4, November.

[21] Although Islamic finance products can be tailored to meet the needs of the involved parties, some of the basic principles cannot be changed. Successful products must also observe certain criteria limitations, and even with these, a broad range of companies is eligible for investment. For example, as of June 2006, theDow Jones Islamic Market Index listed 1,937 companies as being eligible for investment.

[22] Omar Hasan, ‘Islamic finance should diversify, analyst say’ Agence France-Presse (Kuwait 5 September 2010)

<http://www.hurriyetdailynews.com/n.php?n=islamic-finance-should-diversify-analysts-say-2010-09-05> accessed 17 November 2011/11/17.

[23] James Hume, ‘Islamic Finance: Provenance and Prospects’ (2004) Int'1FinL Rev 48.

[24]< http://www.legco.gov.hk/yr09-10/english/sec/library/0910fs19-e.pdf> accessed 8 November 2011.

[25] Oliver Agha, ‘Islamic Finance in the Gulf: A Practitioner’s Perspective’ (2008) Berkeley J. Middle E. & Islamic L., 190.

[26]Aamir A. Rehman, Gulf Capital & Islamic Finance: The Rise of the New Global Players(McGraw-Hill 2010).

[27] See Dina Ibrahim, ‘The Framing of Islam on Network News Following the September 11^th Attacks’ (2010) The International Communication Gazette, Volume 72, No.1.

[28] Ibrahim Warde, ‘The Relevance of Contemporary Islamic Finance’ (2009) Berkeley J. Middle E. and Islamic L., 160.

[29] Gene J. Koprowski, ‘Islamic Banking is Not the Enemy’ (2001) Wall Street Journal Europe. 1.

[30]Jina Moore, ‘Post 9/11, Americans say Muslims face most discrimination: But many also see Islam as a violent religion, according to a Pew Forum survey’ The Christian Science Monitor (11 September 2009) <http://www.csmonitor.com/USA/2009/0911/p02s19-usgn.html> accessed 18 November 2011.

[31] Ibrahim Warde, ‘The Relevance of Contemporary Islamic Finance’ (2009) Berkeley J. Middle E. and Islamic L., 165.