The Financial Crisis and Islamic Banking

Many countries in the Islamic World have adopted elements of ‘Sharia’ (Islamic Law) in their respective legal systems regulating Financial entities.

And how are they weathering this current rather grave financial crisis?

Well, they appear to be doing ok so far, or at least, in our tumultuous western World, we haven’t heard of any Islamic Banks in severe difficulty. European and American Banks, which seemed to be invulnerable, towering examples of stable and modern financial institutions, are falling, stumbling or clinging desperately on to government backed rescue plans.

Should public Money be used to save private debacles? Well, this may be a debate best left for another day.

The question we will look at today is why is it that those Arab countries that have incorporated Sharia principles into their Financial Regulation and are practicing ‘Islamic Banking’ appear to have remained at the margin of the International Financial Crisis.

Some other principles, more focused on ethics and moral conduct, such as the prohibition of the charging of interest or of hiding material defects in the sale of goods, still don’t, or shouldn’t, differentiate Islamic banks from western ones. They are more differences in form. Sharia Law prohibits charging or paying interest, which makes Islamic banks have to achieve an equivalent result in other ways. For example, in a mortgage transaction as carried out with an Islamic bank, only up to 80% of the value of the property may be borrowed, which is very different when compared to some of the lending excesses of western banks in recent years.

And why only 80%? Because one of the requirements of Sharia Law is prudence when taking on risks. Its that simple. Furthermore, the buyer of the property under mortgage is the bank, and the client pays a monthly rent (which would be equivalent to western capital + interest), and the percentage of ownership in the property transfers to the client of the bank as they continue meeting their rental payments.

One might say this is a complicated system, from our point of view in the west, but in essence its similar to a building leasing transaction.

If this lending ceiling of 80% of the value of the property is diligently respected by islamic banks, this certainly is one of the reasons why islamic banking has been less affected by the current crisis.

But there is more… a lot more.

Another requirement of Sharia law is the impossibility of selling that which one does not possess. One must have possession of the object of the transaction. This is another significant difference to some practices in the western World. This simple principle leads to proper asset valuations.

An example of intangible transactions which have become common in the western World but which would be prohibited under Sharia law are transactions involving derivatives and options. If I pay a small Premium which bestows me with the rights to an underlying asset, (foreign Exchange, shares, raw materials, etc) and then I am able to sell these assets in the futures markets, assets, which I don’t yet have in my possession, since all I have in reality is the right to buy, but as yet I haven’t exercised that right.

These types of transactions, under Sharia Law would be impossible, because we would be trying to sell something we still didn’t possess.

All we possess are some rights to purchase the assets, but not the assets themselves.

We all know that many hedge funds are working on this basis, and that many fund managers (bad ones) found an easy way to make easy Money while things were going well.

But in the end, selling what one doesn’t yet possess goes against all logic and it opens the door to speculation, since with a small amount of Money, you can close a transaction with a much higher nominal value.

And this is how things have gone… or better said, that’s how things are going.

If we are looking for an answer to the initial question of this article, why Islamic banking seems less affected by the financial crisis, this is the answer.

Two simple but very important reasons: 
1) be prudent when taking risks, and 
2) don’t sell what you don’t have.

For the Islamic World, its purely the written law.
For the western World its pure logic.

Unfortunately, it appears that the immeasurable ambition of many western fund managers has made them forget logic.

Perhaps we should put logic into law?