Washington, DC

  The Middle East’s increasingly prominent role in the world of international finance has prompted questions about whether banking practices followed by both Islamic and Western institutions are in compliance with Sharia, or Islamic law.

It’s an issue to which Hossein Askari, Iran professor of international business and international affairs at GW, has devoted a lot of time. Wiley published Dr. Askari’s book Globalization and Islamic Finance: Convergence, Prospects, and Challenges in November, and it is publishing The Stability of Islamic Finance: Creating a Resilient Financial Environment for a Secure Future later this month. Dr. Askari’s book Islam and the Path to Human and Economic Development is scheduled to appear in coming months.

Dr. Askari explains that the three requirements for Muslim financiers articulated in the Quran are that Muslims must not borrow or lend money with interest, that all information in any contract must be revealed, and that, in order to bring parties together, business partners must share risk, so that both parties stand to gain or lose based on their investment. Risk sharing precludes a relationship where one party assumes all the risk, and the other reaps a profit even if the former investor does not turn a profit. These three rules apply regardless of the faith of the other party.

Although many banks declare their financial products “Sharia compliant,” they are not offering a product that is truly based on Sharia, stresses Dr. Askari. “What you see today isn’t Islamic finance,” he says. “Most of the banks do not have that risk-sharing component. Investors want a bond, and banks create something that looks like a bond but they say it is not a bond, so that it is Sharia compliant.”

A bond is essentially a loan upon which the borrower agrees to pay interest. By offering sukuks (Islamic bond-like instruments) that exhibit bond-like behavior, which they declare are not bonds, banks have created an $822 billion market, according to a recent article in the Economist. According to Dr. Askari, sukuks make as much sense as transparent hijabs.

As in most economic discussions, it is easiest to explain concepts in terms of widgets. True Sharia permits Muslims to invest in widget production but only if the bank acts simply as an intermediary, Dr. Askari explains. The investor’s returns or losses are directly tied to the success of the widget project. The bank does not promise the investor a return, but would charge fees for acting as the intermediary in the investment. Additionally an Islamic bank can hold deposits for safekeeping and charge a fee for this service.

“A bond with a predetermined return is outlawed. That is what Islamic banking is all about,” says Dr. Askari. “Money cannot earn you money. Money must be invested in real projects, with the return uncertain.”

But Dr. Askari readily admits the sort of Sharia-based banking he describes is not even being practiced in places like Saudi Arabia. “Do you think they deposit money without asking for interest?” he asks.

A CNBC anchor recently asked Dr. Askari how Dubai’s economy could be so troubled when it was supposed to be practicing risk sharing. The answer to Dr. Askari is that Dubai’s system was only Sharia-style, but not Sharia-based. The investors had no connection to the projects that they financed, and they thought that they were getting a fixed return and that there was no risk.

“Many Muslims have memorized the Quran, but they don’t know what it means for economic and financial dealings,” Dr. Askari says.

If Hossein has money to invest and he wants it to be compatible with Islamic teachings and does not want take risks, he might turn to a fancy New York bank that promises a 10 percent return each year, Dr. Askari explains. The bank does not call the return interest, because it must be Sharia compliant. Instead, it solicits a stamp of approval from Islamic scholars it has placed on its board, who are often paid up to a few million dollars each year just for serving on a number of Sharia boards, Dr. Askari says. Hossein leaves happy, believing that his investment is completely legal under Islam. It would trouble him to learn that the scholars often sit on boards of more than one bank, creating a conflict of interest.

In Dubai, all seemed well enough when the banks and the investors were making money and refusing to call interest by its true name. But when the economy collapsed, all of a sudden the investors asked to be bailed out. Dr. Askari sees tremendous irony in this request. If the investments were truly Sharia based, the investors know that they collectively stand a chance to either make money or lose their investment.

The ensuing situation is very confusing, Dr. Askari says. “This is not truly based on the Quran or the life of the Prophet Muhammad, which is what Islam is all about.”

Additionally, Muslims are not supposed to do business with companies that do not follow Sharia law, says Dr. Askari. For example, Muslims should not buy shares in a company like General Electric unless they know that GE has no connections to prohibited behaviors like drinking alcohol, gambling or prostitution. “What if GE has sold shares and has also borrowed money to finance its business operations and is paying interest?” Dr. Askari asks. “To be compliant, you cannot even invest in companies that are paying interest.”

Still, the Sharia-board scholars found a solution. One day they announced that it is permissible to do business with a company if it finances less than a third of its capital needs with bonds. Soon the scholars changed their minds and raised the percentage to 50 percent, says Dr. Askari.

Though he calls much of today’s Islamic banking, as practiced, a “façade,” Dr. Askari thinks its basic theory could serve Western economies well.

Roughly 30 years ago, the financial sector generated about 15 percent of the corporate profits in the United States. Before the recent economic crash, that percentage had leapt to about 40 percent. The problem is that the financial sector does not produce anything tangible, according to Dr. Askari. “Imagine if our whole economic sector was finance,” he says. “None of us would eat.”

Whereas in the past banks were seen as an intermediary to channel money from savers to the best investments, the bulk of their business today is speculation – a field that is explicitly forbidden by the Quran. “Also, the Western fractional reserve banking system creates money out of thin air basically, with no connection to real economic activity,” says Dr. Askari.

One of the factors that has led to the current economic crisis is the “leveraging of the banking system,” in which investors deposit their money in a bank, and the bank lends 90 cents of the investor’s dollar to other institutions. “If you deposit one dollar, you create 10 dollars. The banks then securitize these loans, sell them, get cash and repeat the process,” says Dr. Askari. “Fractional reserve banking creates money and employs leveraging, which you cannot do in Islam.” Nor can you package loans as assets and sell them.

So how is all of this relevant to non-Muslims and to individuals who do not run banks? According to Dr. Askari, 2010 is unlikely to experience a sea change in the Western financial system. “I don’t think anyone is going to use the words ‘Islamic finance,’” he says. “I think we will see more discussion about whether we want to rely more on equity financing, namely risk sharing, rather than debt financing.”

In the past 20 years, economists have noticed trends in the international flow of capital have tended to favor equity flows (like buying stocks in foreign companies) over debt (lending money). Dr. Askari argues in his most recent book that a system of finance that relies more on equity is much more stable than one that relies on debt. Such a system cannot produce the exponential growth that is endemic to speculation, but it also does not produce collapses of such great magnitude.

A business strategy of investing in real projects rather than making money by lending can apply to individuals just as it does to banks.

But ultimately, for some like Dr. Askari, the Quran makes its recommendations for purer reasons than financial stability. “The prophet didn’t talk about this because it was financially stable,” he says. “He said it brings people together. If I come into a project of yours, we have to work together. It builds trust. It brings mankind closer together.

>>> Still, the Sharia-board scholars found a solution. One day they announced that it is permissible to do business with a company if it finances less than a third of its capital needs with bonds. Soon the scholars changed their minds and raised the percentage to 50 percent, says Dr. Askari.

To be fair, there are many legitimate Islamic products available and quite a few reliable Shariah advisory boards.

The issue of a bailout would be different in an Islamically acceptable transaction, precisely because you have acknowledged your loss making transaction, and you would be bailing out ... THE DEPOSITORS ... of course.

Could have discussed the positive role that AAOIFI is playing in this field, or the valid forms of Islamic bonds that are available. Also avoided Takafol (mutual reinsurance) as an important sector of building a stable financial environment. Also the place of Zakaah/Jizyah in sustaining an operating economy. There is lot more academic literature out there and alot that must be done. And finance is after all just one leg of economy.

What always surprises me is how Islamic scholars avoid discussions of positive western values. i.e. Those elements of the fiqh that are exposed to exploitation which have been supported by good western business practice. In particular I refer to fair trade, labour rights, consumer rights, good accounting practice and corporate governance etc. None of which are developed to a sufficient level of sophistication in current forms of fiqh, but from which we can and already do borrow heavily from the western contemporary tradition.

>>> “Also, the Western fractional reserve banking system creates money out of thin air basically, with no connection to real economic activity,” says Dr. Askari.

This is not a fiction as some would have us believe. Americans should know that their financial system has some very poor underpinnings, that is supported by a fifth column of inflation exports and international political thuggery. And it cannot be sustained forever, regardless of the amount of exploitable poor nations there are out there.

Ghulam: Take an economics class.

How is Islamic Finance different from a Credit Union? In a credit union, I'm considered a share-holder who recieves a variable return (albeit, quite small) from the funds I hold there. I don't however, share the risk, since the FDIC says my money had better be there when I want to withdraw it.

Perhaps Islamic finance is more like a Mutual Fund? BTW, the idea of charging a fee for a checking account or storing cash sounds good, but is highly unpopular here.

OmarG >>> Perhaps Islamic finance is more like a Mutual Fund?

Islamic Finance is equity financing. You do not lend money. You become mutual co-owners of an asset. i.e. you'd only become full owner of your home once you've paid your last instalment. Up until then, you're paying rent on your home, buying a share in the asset and receiving your share of the profit from the rental income. It seems complicated, but its quite a fair system. The bank carries the risk of you not paying your rent (so they do not finance for the sake of it) and you never lose any portion of the property that you buy. Another implicit notion is that in Islamic Banking, the depositors actually own the means of financing.

>>> BTW, the idea of charging a fee for a checking account or storing cash sounds good, but is highly unpopular here.

That's because banks create the false impression that your banking fees are low, by paying you lower interest rates or charging you more on the credit you take. The cost of the banking transactions remains the same regardless of how popular the costs are or aren't. By forcing banks to focus on their services and costs, banks must become competitive on the actual service they provide. Rather than use fancy accounting or short changing their depositors with returns.

Fester >>> Ghulam: Take an economics class.

Did you know that the neither Americans citizens nor their own government actually own the federal reserve? Its an independent private bank that lends its dollars from private banks.

Did you know that the neither Americans citizens nor their own government actually own the federal reserve? Its an independent private bank that lends its dollars from private banks.
- Posted by Ghulam

Yes, I knew that. Would you like me to send you the name of a place which does an introductory economics class on-line?

Fester >>> Yes, I knew that. Would you like me to send you the name of a place which does an introductory economics class on-line?

Do you know what that implies about the money supply?

Ghulam: There's a beginning economics class available on-line : http://www.elearners.com/courses/economics.htm look for ECO360.

This class should help you understand more about economics, and it also might get you to ask better questions.

Thanks Fester. Fortunately, I did an economics minor to get my business degree and I've done a fair amount of reading since. So I'm reasonably well read on the subject. Maybe you should take the course, so you could better understand why a person with a Doctorate in Business says "..the Western fractional reserve banking system creates money out of thin air basically, with no connection to real economic activity". You'll be pleased to know that this is not misinformation, and is a well accepted fact in academic and business circles.

Didn't think so...