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Islamic Finance: worth banking on?

Islamic Finance: worth banking on?

The $1 trillion Islamic finance industry has faced some challenges with financial distress becoming the norm. Can Islamic financial institutions be any more ethical, asks E. Shahid.

September 3, 2011 4:12 by

In July 2008, he bought an already overpriced Jumeriah Park property and took almost one million dollars in a loan from a multinational conventional bank. Unlike in Islamic finance, when one buys a property using a conventional bank loan, the interest kicks in from the day the property is bought. “I am now pregnant with this property as the developer [Nakheel] has not delivered the villa. I am bleeding because I have had to pay around $5,000 to $6,000 for 18 months without even getting access to the villa,” he says. The bank has given Aslam some relief, yet he holds the developer accountable for his financial woes.

Professor Rodney Wilson of School of Government and International Affairs at Durham University says restructuring would be as much a last resort for an IFI as with conventional banks. “Islamic banks have to compete with their conventional counterparts. If they were more willing to mark-to-market this could damage their credibility,” says Wilson. According to him, there is no reason why Islamic banks should go beyond their contractual obligations in the recognition of losses.

More tellingly, Wilson says, not every contract offered by Islamic financial institutions so far conformed to Shari’ah principles, but it is too late to do much about contracts already signed. “Lessons have been learnt, and contracts are becoming more distinctive and just to all parties.”

With the retail mortgage market hitting rock bottom in Dubai, the new contracts that Wilson talks about largely comprise Islamic trade finance, which has benefited from shifting preferences toward Shari’a-compliant banking and could help the nearly $1 trillion Islamic finance industry double in size. According to one estimate, the global Islamic finance industry, which has been growing between 15 to 20 percent a year, is widely expected to reach $2 trillion in the next three to five years. While sukuk is expected to lead growth, bankers say Islamic trade finance could propel the industry further.

That is little consolation to buyers that contracted loans and who are largely disinterested in the giant strides the industry is said to be making. They are instead keen to know whether mark-to-market will indeed happen. But yet another issue that surfaces is that of a defined standard and regulation. Atif Khan of Ethica Institute of Islamic Finance says it is possible but unlikely banks will resort to mark-to-market accounting, given that many bankers are now looking at Dubai’s resurgent real estate market as a possible leading indicator for the real estate sector as a whole.

According to Khan, the first step in promoting ethicality in any sector is to abide by an agreed upon standard. “In Islamic finance, the leading standard-setting body is the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), now the default standard in most countries besides Malaysia, Thailand, and Indonesia. Yet we find many financial institutions following highly disparate standards in the absence of any serious regulatory control,” he says.

In Dubai, for instance, the DFSA could begin conducting shari’a reviews based upon AAOIFI in order to ensure that what has already been agreed upon as “Islamic” is indeed being followed.

Exceptions obviously don’t make rules but that doesn’t mean dilution isn’t happening as far as core values of Islamic finance are concerned. Some even admit that many ‘shari’a-compliant’ products are not taking the form they were intended to take. “For instance, we don’t have profit-sharing mortgages or investment for projects that are particularly conducive to social justice and equity,” says Rushdi Siddiqui of Thomson Reuters. “That said, much has been done by several Islamic banks to facilitate socially responsible activities acceptable to Islam and they must be encouraged, given the uphill battle they face, just to convince about the merits of Islamic finance.”

That raises the larger question of perceived similarities between conventional and Islamic banking and the need to maintain their distinct identities. Dr Eckhart Woertz, visiting fellow at Princeton University says Islamic banking seems to pretty much copy conventional banking. “They just give the beast ‘interest’ a different name, ie ‘profit sharing’, but they share the same business models (most of the business of IB is actually disguised fixed income: real estate and car financing, IB credit cards etc.) and are exposed to the same structural pressures,” he says.

Woertz’s concluding remarks go to the extent of shifting the focus of this debate. He doesn’t see this as a question of Islamic banks being more or less ethical in the aftermath of the real estate slump in Dubai. It is about being overexposed to the real estate sector. “In a situation like this I think IB that has financed a project/ customer which/who now under water, faces a problem too. Debt restructuring can be offered to a certain extent, but if the problem is grave they probably need help from the government.”

This article was originally published in Trends, July/August 2011.

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