The modern history of Islamic finance is often dated to the 1970s, with the launch of Islamic banks in Saudi Arabia and the United Arab Emirates. But its roots stretch back 14 centuries. Islamic finance rests on the application of Islamic law, or sharia, whose primary sources are the Koran and the sayings of the Prophet Muhammad. Sharia emphasises justice and partnership. In the world of finance that translates into a ban on speculation (or gharar) and on the charging of interest (riba). The idea of a lender levying a straight interest charge, regardless of how the underlying assets fare in an uncertain world, offends against these principles—though some Muslims dispute this, arguing that the literature in sharia covering business practices is small and that terms such as “usury” and “speculation” are open to interpretation.
Companies that operate in immoral industries, such as gambling or pornography, are also out of bounds, as are companies that have too much borrowing (typically defined as having debt totalling more than 33% of the firm’s stockmarket value). Such criteria mean that sharia-compliant investors steer clear of highly leveraged conventional banks, a wise choice in recent months.
Despite these prohibitions, Islamic financiers are confident that they can create their own versions of the important bits of conventional finance. The judgment of what is and is not allowed under sharia is made by boards of scholars, many of whom act as a kind of spiritual rating agency, working closely with lawyers and bankers to create instruments and structure transactions that meet the needs of the market without offending the requirements of their faith.
Since they have to contort the system so much, it almost seems like this is meant to lessen the guilt of the rich by claiming that this is all in the name of religion. In any case, Islamic financing is indeed growing:
As the buzz around the industry grows, so do expectations. The amount of Islamic assets under management stands at around $700 billion, according to the Islamic Financial Services Board, an industry body. Standard & Poor’s, a rating agency, thinks that the industry could control $4 trillion of assets. Others go further, pointing out that Muslims account for 20% of the world’s population, but Islamic finance for less than 1% of its financial instruments—that gap, they say, represents a big opportunity. With tongue partly in cheek, some say that Islamic finance should by rights displace conventional finance altogether. Western finance cannot service capital that wants to find a sharia-compliant home; but Islamic finance can satisfy everyone.
And now for some reality check:
Confidence is one thing, hyperbole another. The industry remains minute on many measures: its total assets roughly match those of Lloyds TSB, Britain’s fifth-largest bank (though some firms that meet sharia-compliant criteria may attract Islamic investors without realising it). The assets managed by Islamic rules are growing at 10-15% annually—not to be sniffed at, but underwhelming for an industry that attracts so much attention. Most of all, the industry’s expansion is tempered by its need to address the tensions between its two purposes: to serve God and to make as much money as it can.
That is a stiff test. A few devout Muslims, many of them in Saudi Arabia, will pay what Paul Homsy of Crescent Asset Management calls a “piety premium” to satisfy sharia. But research into the investment preferences of Muslims shows that most of them want products that benefit their savings, as well as their souls—rather as ethical investors in the West want funds that do no harm, but are also at least as profitable as other investments.
Ha! I love the term "Piety Premium" - I think this should be levied universally and not just for financial matters (oops...did I say this loud?). In any case, read the full article here and a more readable introduction to Islamic Financing here)