When Scott asked if I could write a post on Islamic Finance for the blog, I nodded with enthusiasm. To be honest I am a relative newcomer to this topic and a non-Muslim, and though while supremely curious I feel I run the risk of offending others on a subject that can be sensitive. Nevertheless, here we are.

The first thing that caught my attention about Islamic finance is its recent origins. Although religious scripts governing Sharia law have been around since Prophet Mohamed’s time, Islamic finance only emerged after the Second World War. It didn’t emerge as a result of new, groundbreaking economic principles, but as a response to a series of clashes between western and Muslim nations, which led to a rise in pan-Islamism.

Among the consequences of this movement was a change in the ways of commerce among Muslims. As Gulf nations withdrew petrodollars they held in the West and began dumping them in their own backyard, cities like Dubai and Kuwait emerged as hubs for the practice and display of Muslim financial piety. By the 1970s, Islamic scholars, economists, and intellectuals were busy studying and interpreting passages of the Quran for the creation of a framework for Islamic finance.

Theological Underpinnings

There are several factors that appear to make modern day Islamic finance different from conventional finance, the most important of which is the prohibition of interest. Wikipedia amply lists all these traits.

Al-Baqarah 2:275 Those who consume interest cannot stand [on the Day of Resurrection] except as one stands who is being beaten by Satan into insanity. That is because they say, “Trade is [just] like interest.” But Allah has permitted trade and has forbidden interest. So whoever has received an admonition from his Lord and desists may have what is past, and his affair rests with Allah . But whoever returns to [dealing in interest or usury] – those are the companions of the Fire; they will abide eternally therein.

But this prohibition isn’t unique to Islam. The Old Testament also regards the charging of interest as immoral. Exodus and Deuteronomy specifically regard lending to the poor as a sin.

Biblical Parallels

Exodus 22:25 - You shall not give him your silver at interest, nor your food for gain.

Deuteronomy 23:19 - Thou shalt not lend upon usury to thy brother; usury of money, usury of victuals, usury of any thing that is lent upon usury

Leviticus 25:37 - Thou shalt not give him thy money upon usury, nor lend him thy victuals for increase

It was only during the European Renaissance when Protestant reformer John Calvin changed the status quo. He argued that not all rules in the Old Testament set out for Jews (who were permitted to lend to gentiles) were applicable to Christians and that one must not interpret these passages in a literal manner. The bible should simply serve as a guide. But Calvin’s real concern was the exploitation of the poor through high interest rates. In Calvin’s letter to Oekolampadius, he writes that he is unwilling to condemn usury so long as it is practiced with equity and charity. Whoever borrows should make at least as much, if not more, than the amount borrowed, meaning that as long as one is fair and reasonable, charging interest should be allowed.

Calvin’s words were such a blow to the Church that interest became legalized across Europe. This was a major turning point in history. It is interesting that Calvin’s view, which forms a basis for modern day capitalism and bank lending, was effectively reversed by Islamic scholars in the 1970s. Is this to say that Muslims, who did business like others in corporate America up until the 1970s, were all of a sudden subject to the new rules of Islamic finance? Yes, in a sense. But there is a twist to it all.

According to Sharia scholars, a guaranteed rate of return on an interest rate is prohibited because the lender and borrower typically bear an unequal level of risk. For example, Sharia scholars prohibit the issuer of a bond to default on an interest payment and then go bankrupt, because those at the bottom of the pecking order virtually have no claim to their monies. Therefore much of Islamic finance is about creating a mechanism that reaps the benefits of bank lending with the appearance of profit sharing (Mudharabah).

Financing Structures

Consider a car loan. If I were to take out a loan in the UK, the bank lends me money and I repay the loan at a predetermined interest rate. Should I become unfit to service the loan, the bank revindicates (repossesses) the car, collects what is owed, and refunds the remainder (if any). If I were to go to an Islamic bank, the bank buys the car, and then sells it to me at a premium, also to be repaid at predetermined intervals (Murabahah). Although I end up paying the same amount under both scenarios, Islamic scholars believe that the latter scenario is only fair because should I default, the bank simply revindicates the car with no further claim on me. In the earlier scenario, the bank may further pursue me for any remaining principal if the repossession doesn’t provide enough. Thus Islamic banks do charge for the time value of money.

Another popular Islamic investment product is a sale/lease bond, aka Sukuk. Suppose I am a property developer and wish to build an apartment complex. I would sell a piece of real estate to a special purpose vehicle (SPV), which raises the funds by selling share certificates. The SPV leases the asset back to the issuer (me), thereby collecting principal plus interest and passes the proceeds back to the sukuk holders in the form of rent. At the end of the lease, the SPV sells or gives the property back to the issuer.

Other types of Islamic financial transactions exist. But to me the above examples are enough to suggest that Islamic finance is nothing more than smoke and mirrors. Islamic finance uses complicated structures to achieve the same goal as conventional finance, but with added cost and decreased transparency. At the end of the day, profit and interest by any other name is still profit and interest. It is hard to imagine that this was the Prophet Mohamed’s objective.

Interest in Indonesia

Having grown up in the world’s most populous Muslim nation, I want to share my observations on Islamic finance in this part of the world. In my opinion Indonesia sees Islamic finance like a dot in the horizon. I can assure you that the majority of business done in Indonesia is definitely not Sharia compliant. Even more fundamentally, more than half the population, which lives in poverty, has probably never even heard of Islamic finance.

The problem with Islamic finance is that it has no global standardization. It emerged in the 1970s in the Middle East, which explains its varying level of demand in different Muslim countries. And as Islamic finance continues to emerge in different parts of the world, it faces the danger of generating greater differences and inconsistencies. A recent Bloomberg article calling for certification among Muslim scholars is further testament to this problem.

Don’t the Saudis own shares in Citi? Are wealthy Indonesian Muslims putting their money into Singapore or their own Sharia banks?  As the market continues to develop, time will tell how market priorities interplay with religious doctrine.