Islamic Finance Helps the Social Doctrine

By Luciano Larivera

Luciano Larivera Journalist for
La Civiltà Cattolica

The development of Islamic finance
Since the mid-fifties, a debate on the possibility of a finance model consistent with the Sharia law (Sharia compliant) was opened in Muslims societies. The Islamic finance originated in the Egyptian village of Mit Ghamr. It was the year 1963 when an agricultural bank, created in imitation of German agricultural banks, started to provide small private entrepreneurs with microloans, thus also promoting the individual habit of saving. Both the recipient of funds and the investor were members of the bank and shared its profits in accordance with Islamic ethic. The economist Ahmar El Najjar, founded the first religious oversight board composed of ulama (Muslim legal scholars). The first oil crisis in 1973-1974 provided Arab countries with the necessary capital to found Islamic financial institutions. In 1975 the Islamic Development Bank was created by the Organization of Islamic Conference. The aim was to promote the development of all Muslim communities in accordance with the principles of Sharia. In the same year the Dubai Islamic Bank, the first Islamic commercial bank not owned by a government, was established. Other Islamic banks were then established in Arab countries, the Philippines, Malaysia and so on. In 1979, Iran Islamized the entire national banking system, followed by Pakistan in the early eighties and then the Sudan in 1992. The previous year had witnessed the bankruptcy of the Egyptian Islamic Bank of Credit and Commerce International. Since then, the Islamic financial service sector, also thanks to the sensitivity of the younger generation to religious ethic, has grown at a rapid pace. Today, it includes almost all financial sectors.
In 2003, the first Islamic bonds (sukuk) were issued in dollars by sovereign countries and then by companies. In 2004, the German state of Saxony-Anhalt issued the first 100 million euro’s worth sukuk outside a Muslim country. The same year, the commercial bank Islamic Bank of Britain was established (the first bank in Europe of this type was established in 1978 in Luxembourg). In 2006, the first investment bank of the continent, the European Islamic Investment Bank, was fully operational. Today, there are more than twenty traditional institutions offering Islamic products in London. In addition, there are several Islamic credit banks in the U.S.A., but not yet in Italy... Muslims are 1.6 billion, one quarter of the world’s population (about 1.4 million in Italy). Today it is estimated that Islamic financial services are available in seventy countries. Before the financial crisis arose between last September and October, this sector was between 750 billion and 1 trillion dollars’ worth. It was estimated that it could increase by 10-15% per year and reach a value between 1,800 and 2,800 billion dollars in 2015. The sector is increasingly open, innovative, sophisticated and competitive. The major Western banks operate in Muslim countries either with traditional and Sharia-compliant credit or through branches dedicated to Islamic financial products. Islamic finance accounts for little more than 1% of the world’s finance [1].
In short, the importance of Islamic finance in the world depends on its extraordinary growth rate and its management model, which is subsidiary and / or competitive with the traditional one.

The principles of Islamic finance
All Islamic financial institutions (IFIs) manage funds without yielding or earning interests.
Islamic institutions select the projects to invest their or customers’ capital. The deposit-holder of an Islamic bank are not real creditors, they are rather investors in a mutual fund or non-voting shareholders. They put at risk their capital in case of losses by the bank. In addition, in the Arab and Muslim majority countries there are often local financial institutions that collect money and pay back the interest. An Arab or Malay bank or insurance is not necessarily “Islamic” even if it belongs to the state [2].
“Islamic finance” is “the combination of organizational structures, transactions, financial contracts that meet the criteria of Islamic law” [3]. Not only do the Sharia rules affect private life, but also the social, political and economic sphere. Although encouraging business and entrepreneurship, the Koran distinguishes between what is allowed (Halal) and what is forbidden (haraam). The scholars of Islamic commercial law (fiqh al muamalat) identify the limits between them. The Islamic ethic aspires to the satisfaction of material and spiritual needs. The main prohibitions affecting the economic sphere are four: the prohibition of interest (riba), which is closely related to the key principle of “participation in profits and losses”: in principle, it is not possible to lend money; [4] the prohibition of gharar (uncertainty, risk); the prohibition of maysir (speculation); finally the prohibition of haraam activities (production and distribution of alcohol, pork, weapons, pornography, gambling, life insurance). The ulema should face possible doubts. For example, is it admissible a leasing for a passenger plane where alcohol is served?
In addition, there is the duty of zakat and the duty to purify, through charity, the money earned in disregard of Sharia. The zakat, the annual tax that every Muslim must pay to help the poor and needy, is one of the Five Pillars of Islam. The rich have a duty to be generous because the accumulation of wealth is legitimate only if it is fairly and reasonably distributed. The faithful and IFIs are allowed to invest in stocks. However, if the suspicion that even a residual part of dividends arouse from haraam activities, an equivalent part of profit on these activities must be purified. On the contrary, equity investments or the purchase of traditional societies where the ratio between debt and equity is more than 33% are strictly forbidden because it is assumed that they connected to loans at interest. The prohibition of riba is intended to preserve a fair and just development of society by preventing every form of exploitation. Today, not only is this rule interpreted as a prohibition of usury, but also as a form of protection for poor from the exploitation of their condition. Islamic law prohibits any form of financial interest. The Sharia prohibits setting in advance a fixed return on the money lent, because money in itself cannot be a “reserve of value.” On the contrary, the payment of fees for additional services is permitted, but cannot be a disguised form of interest. In addition, financial transactions must always be related to commercial activities; namely the purchase of consumer goods, the investment in the production and distribution of goods and services (such as those of Islamic finance). It is neither possible to buy or sell loans nor lend money for this purpose. Besides, trading in goods not belonging to the seller is forbidden.
In Islamic doctrine, as in Aristotle's criticism of chrematistics, money itself must be unproductive. The money must be used as a mean of payment and unit of account. Therefore, it is not possible to reward the lender’s choice to renounce the availability a sum of money belonging to him for a period of time. On the contrary, in traditional finance the interest (apart from usury) is the reward for saving, the opportunity cost. It is the reward for the choice of the investor for the deferred consumption or the lost remuneration for an alternative investment. Besides, the interest includes the “reward” for the risk of losing lent money.
Sharia law requires that the lender be involved, through a fixed percentage, in the profits and losses of the borrower. The financial return does not depend on a fixed amount but it depends on how the good or bad luck of the investment. Generally, structured financial products are considered riba because their main purpose is the purchase of other financial products (derivatives, traditional bonds, haraam stocks) to ensure the return on capital. In these contracts there is no collateral security on loans like pledges, mortgages or leasing. The prohibition of gharar requires that any contract or transaction be free from uncertainty and ambiguity with regard to the vagueness on price, item of sale and content of the contract (for instance, conditions on contingent events). In general, the various financial products based on interest or exchange rate, stocks and commodities (oil, wheat, etc...) fall within that prohibition. Although not being as absolute as riba, the prohibition is relevant. Islamic scholars consider the excess of uncertainty as gambling (maisir), which is prohibited by the Koran. Thus, the betting on the outcome of a future event falls within the prohibition of maisir. For this reason, life insurance in case of death is haraam. The most sophisticated derivatives such as Credit Default Swaps (CDS) would fall under this prohibition because they are often used to bet on the issuer’s ability to pay its debts.

The Islamic organizational model.
The management of the IFIs is functional to the scheme of the umma (the local and global Muslim community). Social responsibility and morality restrain the legitimate ambition for profit. The Islamic doctrine puts the general interest before individualism, but not in a socialist perspective because religious, ethnic, tribal and family obligations are not functional to the state. Private property is not exclusive because the others, starting with family members, have the right to participate in the wealth of their family. This should reduce the most obsessive and aggressive forms of competition, envy and greed in Islamic society. In addition, it will promote equal opportunities, at least for the Muslim male; the productive use of resources in economic and social terms; the growth of human capital and infrastructure.
The organization of an IFIs is structured to prevent prohibited activities while developing business.
This obviously creates tensions on the one hand, but it finds favour in the Muslim believer’s sight. However, Islamic finance products must be competitive with traditional ones. They must offer acceptable services, returns on capital and risks to the owners of the IFIs and their clients, in line with those of other traditional or Islamic competitors. But the critical factor for success, the specific competitive advantage, is to satisfy the wish to save money and to do business in accordance with the Islam. Without such “religious demand” from Muslim customers, the Islamic finance would not have a thriving potential market. The management, employees, shareholders and customers of an IFIs accept a limited degree of management autonomy. Within the organization, a zakat fund is established and managed by an independent board. It collects a part of the customer’s profit and set it aside for social purposes, education, health, etc... This fund, while remaining within the organization, merges with the beit el mal (treasury) of the Muslims, which gather part of the IFIs profit from, as well as donor contributions, inheritances and bequests. However, the highest level of importance and independence are assigned to the Committee of Sharia (Sharia board) consisting of scholars of Islamic law, a sort of ethical committee. Sometimes the Sharia board or the scholars in charge do not are part of the organization. However, their binding opinion is compulsory as well as their role of supervision over financial activities and staff morality. This system favours a more centralized and uniform structure compared to the traditional management models because the religious element supplement business dynamics. The term sulukiat refers to the behaviour and the ethic of the IFIs. It is the blood in its veins. The manager of these organizations must accept the sulukiat, make it grow it and ensure that the staff, as well as the organization’s rules and procedures, conform to its rules. Islamic banks, the most structured Islamic financial institutions, provide religious and moral training for their staff. In addition, the sulukiat is supported through the compulsory prayer (another of the Five Pillars of Islam) that takes place inside the bank during the working hours. In the prayer hall of the bank, after the prayers, the imam preaches a fifteen-minute sermon on religious issues relating to the moral conduct of employees and their behaviour with the customer. A key to the success of the IFIs is the ability of managers to influence the religious conduct of the employees and encourage Sharia-compliant attitudes. To educate these managers and financial experts, an increasing number of university programmes, master’s degrees, conferences, cultural organizations and publications on Islamic finance has been created.
Public authorities seem to watch over the IFIs. No scandal or bankruptcy occurred in recent times. The International Momentary Fund oversees the activities of Islamic banks. Besides, in some Muslim countries, the control of the state and religious authorities over the activities of Islamic banks focuses on the respect of Sharia. The development of Islamic finance is also supported by various Muslim organizations created for that purpose [5]. Besides, Islamic banks also try to adapt to the criteria of “Basel II” of the Bank for International Settlements. This is possible thanks to the cooperation between the Islamic Financial Services Board and the Basel Committee on Banking Supervision. Even the takaful sector tries to meet the international insurance standards [6]. In addition, external auditing and consultancy firms have been established. Alike other “ethical” traditional financial products listed at the stock exchange, major international credit rating agencies ranks the credit-worthiness of Islamic issues and sukuk. Finally, there are already about seventy of stock market indices, such as the Dow Jones Islamic Market Index in many Muslim countries - and soon in the Philippines – and the FTSE Global Islamic Index in London.

Conclusions
The Islamic financial forum of market operators discusses its internal problems, in part similar to those of traditional finance. The IFIs must face these problems to overcome without serious problems the current global recession and to maintain their high growth rates to be competitive. First, they need more qualified and morally responsible financial professionals and ulema. In addition, there is still a lack of mechanisms of corporate governance and transparency to assure savers of investment choices. In the Persian Gulf countries, for example, some investments in real estate will not be successful because the housing market was bloated. The existence of Sharia boards may lead to a conflict of interest when the same ulema is a member of several competing companies committee at the same time, or if they become less vigilant because of the high wage they receive. In addition, there is a need for accounting consistency, based on internationally recognized rules and a shared Islamic jurisprudence. The regulation would increase the confidence of potential customers from other countries. Derivative products are still underdeveloped, but they are necessary to balance the risks. This is a priority because, in times of global crisis, there could be sharp movements in exchange rates and, consequently, significant losses on securities and investments in foreign currency. Islamic banks are also exposed to liquidity risk because they invest in real economic activities, often short-term investment, and they have few assets that can be easily settled. Therefore, IFIs needs to strengthen secondary stock markets also with regard to the takaful insurance sector in order to sell quickly (and without excessive capital losses) their Islamic finance products. Besides, the interbank market for liquidity management is not well developed in the Islamic world [7]. The IFIs are collecting the liquidity of whom is afraid to invest in the western “toxic” financial products. Sharia-compliant financial instruments also attract non-Muslims, such as the Indian and Chinese communities in Malaysia. However, the economic downturn does not offer IFIs great opportunities for a genuine and safe investment; therefore, they find it difficult to expand funding. Nevertheless, Islamic finance is not a fad, another speculative bubble. According to the consulting firm McKinsey, even with an oil price of 30 dollars a barrel, the Middle East will produce an additional financial wealth of 4.6 trillion dollars by 2011.
Islamic finance performs well. However, some consider the instruments of Islamic finance, as well as “ethical” Western products [8], as profit-making intellectual machinery. The sceptic considers them as a form of profit on interest, a camouflage to avoid taxation. This accusation is general and not detailed. Sharia boards dispel all doubts. Another suggestion is that the instruments of Islamic finance, like petro-dollars in the seventies, is the Trojan Horse of the Islam to Islamize and colonize the word. This is definitely not the outlook for the next years. Unfortunately, this opinion project in the economy a model of relations among peoples and religions based on the idea of the “clash of civilizations.” It is true that the financing of jihadist terrorism uses the tools of Islamic finance. However, a long-lasting international cooperation at an international level has been established with the participation of Arab and Asian Muslim countries, to fight these crimes. On the contrary, there is a “dialogue of civilizations” in progress. Islamic finance is frightening some market operators because, given the huge number of potential customers and the yields on hydrocarbons, it may erode the role of “our” financial operators in global and then national markets. However, the Islamic finance sector is open to everyone. In addition, on the one hand, large Western banks and insurance companies operate successfully in Muslim countries pushing their Islamic competitors to efficiency in order not to exit the market. On the other hand, Islamic finance helps to finance the public debt and the economy of the rest of the world. This may help to jump-start the word’s economy. Indeed, Islamic finance, fuelled by the income of many migrants, is a source of funding for the development of sub-Saharan African countries in several sectors, namely, tourism, telecommunications, infrastructure, logistics and, hopefully, agriculture in the near future.
The non-Muslim Italian investor, willing to entrust their savings to those who invest in real and sustainable development, may also choose to invest in Western “ethical finance.” However, there are no a hundred per cent sure investments, especially when there is a downturn in the economy, even for investment in ethically worthy public and private initiatives. The global economic recovery will depend neither on the replacement of the free market with statism or protectionism nor on the distrust of Western capitalism’s ability to improve. However, public intervention will not suffice if there is no trust among market operators.
The current financial crisis has also attacked and destroyed the “relational assets” of the global economy. Economic institutions need to recapitalize also on an ethical and religious level, which foster responsibility, solidarity, hope and trust. Islamic finance, as well as other Asian spiritual and religious traditions, can contribute to the ethical recovery of the global economy. The West, however, can count on the tradition of the Christian social doctrine and on the patrimony of experience, reflections and organizational solutions under the “Corporate Social Responsibility”. The time has come to achieve and perform a genuine and pervasive corporate social responsibility [9]. By Luciano Larivera, Journalist for La Civiltà Cattolica Many thanks to La Civiltà Cattolica for the contribution.

[1] After the onset of recession in 2008, the number of sukuk issued fell to 14.9 billion dollars, compared to 34.3 billion dollars in the previous year. But it is assumed that, when liquidity is again available, there will be an increase in issues by 30-35% annually, alike the previous year. By 2010, it is expected that 50% of the financial activities of the six countries of the Gulf Cooperation Council (Saudi Arabia, Bahrain, United Arab Emirates, Kuwait, Oman, and Qatar) will be run according to Sharia; 20% in Malaysia; 10% in Pakistan, Bangladesh and Indonesia. Today, the UK manages more Islamic funds than Pakistan.
[2] Even the famous Muhammad Yunus’ Grameen Bank, Nobel Prize in 2006 for peace, is not an Islamic bank. Indeed, it usually lends money at interest. The Grameen Bank is an “ethical bank” founded by a Muslim for Muslims. It promotes social development through microloans to small entrepreneurs, especially women. Besides, the role played by the woman in microloans is contrary to the more strict ethic of Muslim Saudi Arabia.
[3] Hamaui, R. – Mauri, M. (2008) La banca islamica: prospettive di crescita e questioni aperte in Bancaria No 6, p. 20 see also Adamo, R. – Federico, D. – Notte, A. (2008) Il boom della finanza islamica. Spunti di riflessione da alcune operazioni di cartolarizzazione, in Bancaria No 12, 77-94; Siagh L. (2008) L’Islam e il mondo degli affari. Denaro, etica e gestione del business. Milano: ETAS
[4] The Sharia permits only beneficial loans (qard al hasan) to support unforeseen costs such as funerals, health emergencies; extra expenses as a marriage or the circumcision of a child. It should neither breed interest nor commissions. Only the borrowed sum of money can be paid back. God will reward the lender. The hiba (gift) is instead a remuneration on current accounts that is not foreseen by the contract. This is taken from bank reserves and may be paid to reward customers when the return on investment is lower than expected.
[5] For instance, the Islamic Development Bank (founded in 1973, based in Jeddah in Saudi Arabia, consisting of 56 Member States) supports multilateral development; the Accounting and Auditing Organisation of Islamic Financial Institutions (operational since 1990, with headquarters in Bahrain, consisting of 140 Member Institutions) sets standards for accounting, auditing, governance and morality; the Islamic Financial Services Board (established in Malaysia in 2002 with the support from the International Monetary Fund and consisting of 110 members) promotes the stability of Islamic finance services by issuing prudential standards and guiding principles on capital adequacy and risk management; the General Council for Islamic Banks and Financial Institutions (operational since 2001, with headquarters in Bahrain and private members and independent regulation authorities) promotes Islamic finance; the International Islamic Financial Market (operational since 2002 and based in Bahrain and established by the central banks of some Islamic countries), promotes the development of primary and secondary markets for Islamic financial services; the International Islamic Rating Agency (operational since 2005) rates Sharia-compliant equity and debt.
[6] The conventional insurance contract is prohibited for being disrespectful. The lost of a loved one, the loss of property or damage is the Will of Allah. In addition, insurance can give rise to speculation (maisir) and cause uncertainty (gharar), in the case a reward is associated with an uncertain or higher benefit then the insurance premiums. The Islamic insurance (takaful) is structured as a mutual aid association. Policyholders cooperate in creating a fund to draw resources for the payment of the compensation: there is no trading of securities. The fund also invests in non-prohibited activities (thus, excluding riba, gharar and maisir activities).
[7] Countries such as Italy will more easily permit the establishment of Islamic banks when clear criteria to ensure a level of international reserves and equity consistent with that of the national operators are guaranteed. Sharia-compliant IFIs wishing to operate in Italy as banks should increase their capital (internal and external capital, as well as their participatory capital at the Bank of Italy) as a guarantee for their clients, especially in the case of refinancing through the interbank market or the Central Bank.
[8] In the West, the “social responsible saving” arose in the sixties in the Anglo-Saxon countries. In this context, investments must not only be evaluated according to parameters of risk and return, but also according to the ethical issues related to the company or the country that issue the debt. In the U.S.A. there are about 260 "ethical investment funds" with assets of around 200 billion dollars (before the financial crisis). In Europe there are almost 550 ethical investment funds with assets of 50 billion euro. Ethical finance in Italy has developed since the second half of the eighties. More than 20 ethical funds were operating in our country at the end of 2008, with assets around 2.5 billion euro. These funds belong to traditional commercial or people’s banks, such as the Banca Etica.
[9] See: Sacconi, L. (ed.) (2005) Guida critica alla responsabilità sociale e al governo d’impresa. Problemi, teorie e applicazioni della Csr. Roma: Bancaria Editrice; Zappi, G. (ed.) (2005) Linee guida operative sulla responsabilità sociale d’impresa in banca. Creare valore ascoltando gli stakeholders. Roma: Bancaria Editrice; Ciminello, R. (2008) Il significato cristiano della responsabilità sociale d’impresa. Roma: Tipar Graphic Arts.