September 2011

September 25  |  September 19  |  September 11  |  September 5


SEPTEMBER 25, 2011

This week I raised an issue of whether two groups–who I labeled as the pragmatists and the idealists–within Islamic finance are speaking past one another on the issue of using profit0and-loss sharing versus the financially engineered products that dominate the industry.  I said they were speaking past one another because they have missed a key point of discussing whether the idea of combining contracts is valid, which serves as the basis for Islamic finance and the financial engineering of new products.

However, abstracting from this argument, the PLS supporters seem unwilling to even allow for the possibility that products besides mudaraba and musharaka are valuable for Islamic finance.  I have written about this idea before and I still maintain that the use of debt-based products like murabaha and ijara, even where they are not used in conjunction with other products are valuable because they meet a financial need for an alternative to conventional banking.

However, one thing that the industry’s current reliance on these products creates is more difficulty in appealing to non-Muslims because an ijara- or murabaha-based loan, while different in structure from a conventional loan, does not offer much to differentiate Islamic finance from conventional finance.  One of the things that I and others have argued is that the Islamic finance industry should and could attract  more non-Muslim participants.

In markets like the US and Western Europe where the Muslim population represents a small minority, this is probably a necessity for the industry to reach sufficient scale in these countries.  However, without having something different, they are forced to compete on price alone, or by declaring that Islamic finance is ‘different’, even when these differences are likely minor in the eyes of consumers.  This will make it hard for the Islamic financial industry to make inroads into the non-Muslim market where the Muslim population represents a small minority.

Yet, at the same time, the regulatory environment is likely to be less willing to make accommodations to the Islamic finance industry to allow the types of PLS products that would serve to differentiate Islamic financial institutions from conventional ones.  The difficulty is more acute in banking because the regulations are tighter than in most other areas of finance.  Currently, I don’t have an idea of how Islamic finance can surmount these difficulties and I am always interested in hearing what readers of the newsletter suggest.  Hopefully, there will be future newsletters or blog posts on this topic.

SEPTEMBER 19, 2011

I am currently in Washington, DC visiting family and preparing to attend the US-Qatar Business Council’s Islamic Finance Forum this Wednesday, which will be held at the George Washington Law School.  In addition to my work on Sharing Risk, I cover the Americas for The Islamic Globe, a newspaper on the Islamic finance industry (subscribe for free on the website,

Within the past few weeks, I have written articles about  real estate investment by GCC-based investors in the US (specifically in the DC metro area).  One is an apartment purchased in Virginia by the joint venture between Kuwait Finance House and UDR, a REIT based in the US.  Another, funded by Qatari Diar, is a large development in DC called CityCenterDC.  Seeing these projects reminds me of the potential for the US to be a destination for Islamic financial institutions looking for geographical diversification.  At the same time, some investors, like Unicorn Investment Bank–which recently exited its US portfolio–and Arcapita, which sold its remaining stake in the US coffee chain Caribou Coffee (the second largest behind Starbucks) are exiting the US market to focus on their ‘core’ markets.

While the new investments into the US are promising if they can lead to further investments from the same and other investors, the exits by Arcapita and Unicorn are also promising because they show that the market is developing some liquidity and also because valuations are recovering from the US recession (which may seem as if it is still ongoing to many Americans).  However, the sign that investors can exit the market without losing their shirts, even after a lengthy and deep recession that significantly damaged valuations, particularly of real-estate related investments, should give some investors confidence that the US market remains resilient.

Still, the US recession has left the stock markets (perhaps an imprecise proxy of all US company valuations) well below the pre-financial crisis levels.  This should provide careful investors from the GCC and other regions with opportunities to invest in the US market.  At the same time, despite all the furor around Islam and Islamic finance in the US (which is marginal at best as a recent report from the Center for American Progress demonstrated), the laws of the US and the financial markets are no less open to Islamic investors than they were before the crisis.  The US still has many fewer barriers, both regulatory and with regards to taxation, than many other Western countries.  Hopefully we shall see more Islamic investors looking to the US as a stable geography with good investment opportunities and few barriers to investment.  It will be good for the investors as well as for the US.

SEPTEMBER 11, 2011

It is common for people to describe the potential of Islamic finance beyond just Muslims based on its socially responsible or ethical foundations.  However, given the structures used and limited screening methodology (focusing only on excluding what is prohibited outright), without any consideration for activities which may not be prohibited outright, but which are socially detrimental, such as environmental and labor standards.

Even beyond this critique, some (myself included at times) focus solely on the “asset” side of the balance sheet and criticize the use of products that are functionally equivalent to conventional lending, but which have been re-structured to be sale or lease contracts instead of ones based on interest.  Part of the criticism is that by acting the same way as conventional banks, albeit with different contracts, there is no “ethical” benefit to Islamic finance.  However, that does miss the conflicting demands an Islamic bank (like any bank) faces between interest groups which may have different objectives and to which the bank may have different levels of responsibility.

For example, as pointed out in this article, giving additional forbearance on a loan or renegotiating the terms beyond what is required in the contract or under the laws of the country in which it is executed, it may be viewed as more ethical by borrowers (and people whose interests are aligned with that borrower, like other debtors to the bank who may expect similar treatment).  However, it will be viewed very differently by the bank’s depositors and shareholders, who will see a lower return on deposits or on their shareholdings in the bank.  To them, while the action of the bank may have been charitable, it was done not with the bank’s money, but at the expense of the depositors or shareholders’ return.

As a result, it becomes more of a challenge to decide whether an Islamic bank is ‘ethical’ simply by viewing how it treats borrowers who are in distress, either because of factors out of their control like an economic downturn, or where they overextended themselves by buying a property they could not afford (in the latter case, some of the responsibility lies with the bank for not analyzing the borrower’s ability to pay).  In normal times, and where there are no disputes about the bank acting in bad faith, it is perfectly ethical for a bank to demand repayment or to foreclose on the borrower to minimize the loss of depositors and shareholders.

However, in strained times, when there is a general economic downturn, especially when a lot of the bank’s assets are exposed to a particular sector that has been hit hard, the Islamic banks should react differently and consider offering payment moratoriums, reducing the amount borrowers owe.  However, it should not do these out of charity to the borrowers, it should do so out of the responsibility to maximize the return (or minimize the losses) to shareholders and to protect depositors.  It should be a strictly economic decision–if the bank has high exposure to real estate, it cannot hold onto hope that all of the assets it holds will be worth their book value.

By getting in front of the problem and determining what assets are impaired and which are not, it can decide how to maximize the value of its assets.  If the Islamic financial contracts and the bank’s balance sheet is simpler and clearer than a conventional competitor, then it should be easier to identify losses, supplement capital where needed and move forward than in a conventional bank with a complicated balance sheet where its assets are more difficult to understand and value.  This may be more ethical in the end, but only if the bank ‘s management is willing and able to deal with the problems quickly.

If Islamic banks keep their operations simple and don’t get too heavily leveraged with balance sheets filled with assets that are difficult to impossible and the management is honest with itself and its constituencies, then it may be judged to be more ethical.  The screens used in Islamic finance (particularly those relating to gharar and maysir) may tie the hands of management in a good way, it cannot be relied upon to keep the Islamic banking system any safer than the conventional banking system, or more ethical and transparent.  Combining the limitations on some types of activities may help, but in the end qualified, competent and ethical management has to be in place for the ethical ideas to be translated into practice.  Another reason why Islamic banking should not be viewed as inherently better, more ethical or more stable than conventional banks.


It is Labor Day here in the US, so the newsletter will return next week.  For those of you in the US and Canada enjoy the holiday and check back next week.