Opinion: Mahmoud El-Gamal: Incoherent pietism and Sharia arbitrage
Published: May 23 2007
Vying for countless billions of Arab petrodollars, unexpected champions of “Islamic finance” have emerged in unlikely places. Most recently, the growing list has included Gordon Brown, the UK’s Chancellor of the Exchequer, and officers of the Monetary Authority of Singapore. Emerging financial centres in Bahrain, Dubai and Malaysia have grown with Islamic finance, but now the industry’s size has piqued the interest of more traditional centres.
Most notable has been the growth of the market for bond-like instruments known as sukuk – the plural of sakk, an Arabic precursor of cheque, meaning certificate of debt. Curiously, Eastern indulgences were called “absolution certificates” or sukuk al-ghufran. Other Arabic words have populated the world of Islamic finance: murabaha, ijara etc. Competition for this market niche has brought anglicised versions of those words into major conferences from New York to Singapore.
So, what is Islamic finance, really? As the name suggests, Islamic finance is first and foremost about religious identity. It first appears in the writings of the intellectual forefathers of political Islam and their students.
The simplistic economic view of these writers – paradoxically echoed to this day, not only by religious figures, but also by Western regulators – is that Islamic scripture forbids all types of interest. As I, and others, have shown in detail in academic publications, traditional religious scholarship does not support application of this simplistic view to modern finance. Indeed, the very practice of Islamic finance today is interest based.
If all interest is forbidden, then, in principle, the solution is to build all financial intermediation on equity-based profit sharing. The practical solution – which I call “Sharia arbitrage” – is to use legal devices, often employing special-purpose vehicles or SPVs, to restructure interest-bearing debt, collecting interest in the form of rent or price mark-up. Designing such instruments and their certification as “interest free” constitutes the bulk of Islamic finance.
One of the most popular models is the sale/lease-back bond structure, known by the exotic name sukuk al-ijara. A bond issuer sells some real estate or other assets to an SPV, which raises the funds by selling share certificates. The SPV leases the assets back to the issuer, thus collecting principal plus interest and passing them along to sukuk holders in the form of rent. At the end of the lease, the SPV sells or gives the property back to the issuer.
In a well-structured sukuk issuance, payments would continue to the sukuk holders, even if cash flow from the underlying assets were to stop. The repurchase agreement thus acts also to ensure that sukuk holders are exposed only to the issuer’s credit risk. The role of religious-scholar consultants is to sustain the fiction of conducting a different type of finance, while keeping the associated transaction costs of that fiction minimal. Those structures have been popular only since 2000, and their risk structures have not yet been tested legally in bankruptcy or other proceedings.
A stalwart of Islamic banking, the buy/sell-back murabaha transaction, has endured two legal tests, in which British courts disregarded Sharia provisions and enforced English law. In the two cases of Islamic Investment Company of the Gulf v. Symphony Gems NV (2002), and Beximco Pharmaceuticals v. Shamil Bank of Bahrain EC (2004), courts ruled against Islamic-bank debtors, who had argued that the transactions amounted to unsecured interest-bearing loans and therefore violated Islamic provisions, and allowed the Islamic banks to collect their accrued interest.
Spurious sales and leases that rename interest as profit or rent are not without cost. Additional costs of these inefficient transactions are passed on to the customers. Fortunately for the customers, perhaps, but most fortunately for financial providers, regulators have been surprisingly accommodating, for instance eliminating double taxation on property-flipping murabaha (in which a bank buys a property, then sells it on credit immediately) for home finance in the UK.
The primary beneficiaries of Islamic finance are international law firms. Rising interest in an exotic legal system – one that appears to promote the use of sale/lease-back structures to disguise interest-bearing debt – was the greatest gift that one could give to skilled legal arbitrageurs who are experts in structured finance.
The second set of beneficiaries has been the premier multinational banks, who have driven Islamic financial innovation (re-engineering is a more apt description) in both investment and retail banking.
The third set of beneficiaries has been self-styled religious “scholars” and “experts”, who are retained as consultants to certify the Islamicity of re-engineered financial products.
The earliest Islamic banking experiments in India and Egypt were small rural co-operatives inspired by European mutuals. They focused on economic development, poverty alleviation, and fostering a culture of thrift among poor Muslims. The true heirs of this tradition today appear to be microfinance institutions, not the multinational banks championing Islamic finance.
For now, “Islamic finance” thrives on incoherent pietism. On the one hand, its proponents justify the efficiency losses to their customers as the “cost of being Muslim”. On the other hand, they rouse misplaced religious pride in the industry’s growth, with surprisingly frequent claims that its modes are, or will become, unequivocally superior.
Most observers find contemporary Islamic finance harmless enough, drawing analogies to kosher water or organic tomatoes. However, it is symptomatic of more serious problems. The modus operandi of Islamic finance is worrisome for two reasons: it glorifies irrational adherence to outdated medieval jurisprudence, and supports the development of a separatist and boastful Islamic identity. This mixture has proven disastrous in recent years, and Muslims can hardly afford its economic price.
Mahmoud El-Gamal is chair of Islamic economics, finance and management at Rice University, Houston. He served as scholar-in-residence on Islamic finance at the US Department of Treasury in 2004. His book Islamic Finance: Law, Economics and Practice was recently published by Cambridge University Press.
Copyright The Financial Times Limited 2008