Monday, July 19, 2010

On Islamic banking

We sometimes fail to realize how much our worldview is shaped by that little part of the world in which we live. Ever since I was a paperboy for the Washington Star-News, I've always had a concept of a bank as a place in which money earned interest. The interest was not necessarily related to anything tangible, but it still accrued because there were people who wanted to use my paperboy money and were willing to pay a premium for it.

Well, if I had been a paperboy for a newspaper in Riyadh, I would look at life very differently. And perhaps those who are better traveled than I can comprehend the first paragraph of this BusinessWeek article:

Bahrain, the Middle Eastern country with the largest number of Islamic banks, aims to grab a greater share of sukuk trading from the U.K., Dubai and Malaysia with a bourse dedicated to securities that adhere to Shariah law.

The rest of the article is here, but I never really got past the first paragraph. I know what Shariah law is, but I don't know what "sukuk" or "bourse" mean. (As I'll note later today, investment is not my strong suit.) But more importantly, what is an Islamic bank?

I figured that the best way to educate myself on this would be to visit the Islamic banking page for the Institute of Islamic Banking and Finance. Let's start at the beginning:

While elimination of "Riba" or interest in all its forms is an important feature of the Islamic financial system, Islamic banking is much more.

Now that much I knew - interest is not compatible with Muslim ethics. (And this issue isn't limited to Islam.)

At the heart of Islam is a sense of cooperation, to help one another according to principles of goodness and piety (but not to cooperate in evil or malice). In essence, it aims to eliminate exploitation and to establish a just society by the application of the Shari'ah or Islamic rulings to the operations of banks and other financial institutions.


Islamic finance may be viewed as a form of ethical investing, or ethical lending, except that no loans are possible unless they are interest-free.

As part of those ethics, an Islamic investment firm is not going to invest in a winery or a pig farm. But this shouldn't just be viewed in a negative light.

What makes the trader, banker, agriculturist or research and development scientist perform his job to the best of his ability? In capitalist economies, it is the notion of competition. This involves the necessity to constantly produce more new things for profit to keep up with others and this makes for wastage and often generates unbridled greed. But in an economy based on Islamic principles, the idea of man representing God on earth gives businessmen a feeling of co-operating with others for the good of society as a whole, including himself. Thus Quranic guidance enables man to conserve and use prudently all the resources of the earth that God has given mankind.

This is embodied in the way that Islamic banks actually make money. This illustration helps to clarify this:

Consider two persons, one of whom has capital but no special skills in business, while the other has managerial skills but possesses no capital....The two persons co-operate with each other on the basis of partnership, where the capital-owner provides the capital and the other party puts his management skills into the business. The capital-owner is not involved in the actual day-to-day operation of the business, but is free to stipulate certain conditions that he may deem necessary to ensure the best use of his funds. After the expiry of the period, which may be the termination of the contract or such time that returns are obtained from the business, the capital-owner gets back his principal amount together with a pre-agreed share of the profit.

The ratio in which the total profits of the enterprise are distributed between the capital-owner and the manager of the enterprise is determined and mutually agreed at the time of entering the contract, before the beginning of the project. In the event of loss, the capital-owner bears all the loss and the principal is reduced by the amount of the loss. It is the risk of loss that entitles the capital-owner to a share in the profits. The manager bears no financial loss, because he has lost his time and his work has been wasted. This is, in essence, the principle of mudarabah.

It has also been described in this manner:

One key element of Islamic finance is the requirement of an element of risk normally associated with doing business. However, one must keep in mind that risk in business sharing is allowed whereas risk in the form of gambling or mere speculation is prohibited by Islamic Law. The main idea is that investors should spend their effort searching for projects that are sound, that adhere to the Shari'a, and share in the success or failure of the project. The objective is that investments should provide a stimulus to the economy and encourage entrepreneurs to maximize their efforts. The profit or losses should be shared by all parties involved and earnings may not be guaranteed or predetermined.

Now I'm not certain about the mechanical differences between such a system and a stock market, but perhaps I'll figure it out eventually. (Or maybe there is no difference, and an Islamic bank functions like a mini-stock exchange, only with ethics.)

So, what is sukuk? Investopedia helped here:

An Islamic financial certificate, similar to a bond in Western finance, that complies with Sharia, Islamic religious law. Because the traditional Western interest paying bond structure is not permissible, the issuer of a sukuk sells an investor group the certificate, who then rents it back to the issuer for a predetermined rental fee. The issuer also makes a contractual promise to buy back the bonds at a future date at par value.

As for "bourse," Investopedia simply defines it as "any European stock exchange."

So now I can comprehend that paragraph of first paragraph of the BusinessWeek article:

Bahrain, the Middle Eastern country with the largest number of Islamic banks, aims to grab a greater share of sukuk trading from the U.K., Dubai and Malaysia with a bourse dedicated to securities that adhere to Shariah law.

And my question on Islamic finance and stock markets is effectively answered.
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