International corporations that dismiss Islamic finance as a grab bag of weird practices to fund terrorists ought to think again. They are missing out on one of the world's fastest' growing capital pools—and one that is beginning to be drawn into the mainstream of the global financial system.
Contrary to Islam's bad image in the Western political press, the vast majority of devout Muslims are as peace-loving and politically moderate as people of any other religion. And indeed most banking and finance in Islamic countries is of the conventional Western and Asian variety. But increasing numbers of Muslims—particularly the younger generation entering their 30s and 40s, who are well educated in both religion and finance—want to participate in the global market in ways consistent with the structures of al-shari'a, Islamic religious law, best known for forbidding riba, which is usually construed to mean the charging or paying of interest (see "What Exactly Is Riba?"). Since interest lies at the heart of all debt finance in the rest of the world, that ban has kept Islamic finance isolated.
Until now. Suddenly, in the past half year or so, investment managers and bankers on both sides of the divide are deviling clever ways to couple Islamic and conventional finance and open up a new source of funding. Among the most innovative are such Islamic financier as Iqbal Ahmed Khan, who runs Bahrain's Islamic Investment Company of the Gulf, which is part of die Dar al-Maal al-Islami Group (DMI) headed by Saudi Prince Mohammed al-Faisal al-Saud, and Adnan al-Bahat, who set up The International Investor (TII) in Kuwait in 1992 as a wholesale investment bank bridging the two financial systems by providing Islamic vehicles to such partners as Swiss Bank and Japan's Nomuta Securities.
Leading die innovators in Malaysia are Nor Mohamed Yakcop, a former adviser to the country's central bank who now advises fast-growing Abrar Group international, and Wan Abdul Rahim Kamil, who built a big reputation at Bank Islam Malaysia for structuring Islamic debt securities and was hired last year by Abrar to head its Jati Discounts investment banking arm.
The transformation of Islamic finance is nor without geostrategic implications: if the Islamic world can be integrated into international finance and the global economy, future conflicts between Muslims and the West will likely be vastly reduced. For all its swift growth, Islamic-proper capital is still a relatively modest sum. Because it is scattered in more than 100 Islamic banks and investment houses in dozens of countries—and also lodged in the Islamic departments of such conventional financial institutions as Citibank, Kleinwort Benson, and ANZ Grindlays Bank—guesstimates range all over the lot. Islamic banking's most enthusiastic proponents put it as high as $150 billion. A more realistic range would be $60-80 billion. If, as is widely believed, it is growing at 10-15% a year, it ought to exceed $100 billion before the end of the decade.
That would still amount to less than 10% of the total capital in Islamic countries. In Kuwait, however, the Islamic portion is already close to 25% of the total— an indication of how much growth could come elsewhere. Malaysia's goal is to reach 25% within the next four years. Al-Bahar goes so far as to say: "In my view the Islamic market wilt be responsible for managing at least 40-50% of the total savings of Muslims worldwide in 8-10 years—and eventually something in the range of 80%."
The betting is that as new Islamic investment products become available, sizable sums will swing out of conventional institutions and into Islamic ones. Says Stella Cox, assistant director of Middle East banking at London investment bank Kleinwort Benson: "We see some of the big corporations in the Gulf region and the families behind them realigning their investment and financing criteria m accordance with Islamic shari'a."
For that reason some conventional banks are shifting deeper into Islamic finance. Citibank, jokingly known in London as "the world's largest Islamic financial institution" because it manages some $12 billion in short-term Islamic trade finance and private investments, set the Gulf bulling a month ago when it disclosed that it would open a separate Citi Islamic Investment Bank in Bahrain in July. Heading it will be two Mideast Citibank veterans: Mohammed al-Shroogi, who will be chairman, and Shafqat Ali Memon, who will be managing director. But Citibank isn't alone. The Netherlands' ABN-AMRO is opening a similar bank in Bahrain, as is Arab Banking Corporation, a conventional Saudi bank whose past strategy was to become more European. Union Bank of Switzerland, Dutch banking group ING, and Britain's NatWest are launching Islamic operations in London.
Meantime, some of the smartest global companies are already tapping this new capital source, especially for leasing and project finance deals. General Motors, IBM, Xerox, France's Alcatel, and South Korea's Daewoo have all raised money through an Islamic leasing fund set up in the United States by United Bank of Kuwait (UBK). German companies are starting to look at Islamic capital, too, since Dresdner Rank acquired Kleinwort Benson, which has more than $1 billion of Islamic money under management. Two months ago Metallgesellschaft raised $30 million in a short-term Islamic financing in Bahrain—as did Daewoo.
Project financings are starting to include components tailored to attract Islamic savings, especially in Malaysia. More than a third of the $2.1 billion raised last month foe the new Kuala Lumpur airport was Islamic funds raised by Bank Islam. And Abrar intends to raise all the funds for an express tail link to die new airport with Islamic capital. In March a syndicate led by Bahrain's Islamic Investment Company of the Gulf raised $70 million in Islamic funds for Saudi Arabia's Holy Sites project to develop road and pilgrim shelters between Medina and Mecca.
"Islamic finance will become a very big, established player in project finance over the next five years," predicts Richard Duncan, director of Islamic finance at ANZ International Merchant Banking, an arm of ANZ Grindlays. An Australian bank, ANZ got into Mideast finance in a big way in 1984 when it acquired Britain's Grindlays Bank, which had the old Ottoman Bank network. It then pulled off the first Islamic project financing in 1993. When Pakistan's Hub River Power Project ran short of cash, ANZ arranged for an Islamic financing house to supply $92 million against title rights to the turbines to he produced. It was a break-through deal that Pakistan's Federal Shariat Court ruled was not a loan but a purchase and resale (to the project developers) of the turbines. Under shari'a, sharing in the profits of productive pursuits is acceptable.
Other project financings are now in the works for Pakistan, and the International Finance Corporation, the World Bank's private sector arm, has begun to seek ways to mobilize Islamic capital in an effort to tap Gulf capital, the IFC has developed a new instrument, income participation notes, to finance trust financing (mudaraba) companies in Pakistan that do a lot of leasing. It is now looking for Islamic institutions to make a market in the notes.
A great deal of innovation is occurring in other financial products, too. "Islamic financial players, whether in the Middle East or Asia, are very interested in participating in the global capital markets," says Nagib Baroudi, who heads Islamic banking at Citibank's private bank in London. "Like any other investors, they seek asset diversification."
The great debate is between debt financing and equity financing," says Mushtak Parker, editor and publisher of Islamic Banking in London. "The purists see finance as equity financing. The innovative group sees Islamic finance as a total banking concept." A slew of mutual funds have been bunched in recent months, by Islamic as well as conventional institutions, to direct Islamic savings into stock markets of both emerging market and developed countries. Despite the Islamic ban on interest, several experiments in bonds and other debt-like instruments are under way, not only in Malaysia but also in London, Bahrain, and Iran, which is trying to model its Islamic financial system after Malaysia's. Shari'a forbids insurance against acts of God, which makes life insurance impossible, but much can be done to develop mutual property insurance, and a new company, Qatar Islamic Insurance, has started insuring project finance deals. Local home mortgage cooperatives have been springing up in Islamic communities in the United States and Canada, and Kuwait Finance House and UBK have started a mortgage company in Britain.
Interest payments may be forbidden in Islam but installment sales aren't, so Islamic mortgages work the same way the Hub River turbine deal worked: the mortgage company buys the home and resells it to the client on a 7-15-year installment plan. Islamic bonds work on the same principle: A facility set up to issue bonds acquires equipment or property, sells it to the operator over time, and distributes the markup on the installment payments to bondholders in lieu of interest payments. The technique is called murabaha, or cost-plus financing.
One sign that the innovation is feverish is the fact that a group of conventional and Islamic financial institutions have teamed to sponsor a study at Harvard on how to design produce for the Islamic marker. The sponsors include New York's Goldman Sachs (whose J. Aron commodity trading arm is an old hand at Islamic commodity financing), Boston asset manager Wellington, US pension fund consultants Frank Russell, the Islamic Development Bank, and Saudi Arabia's National Commercial Bank.
Islamic finance is only now catching the world's attention because it is in fact relatively new. All but forgotten during the colonial era, it began its slow renaissance in 1963, when an Egyptian banker named Ahmad al-Najjar opened a tiny savings bank based on profit sharing instead of lending in the town of Mit Ghamr. He kept his operations quiet; the Nasser government frowned on anything that smacked of Islamism. But his ideas stimulated Malaysia to found a company in the same year to help Muslims save money to make the hajj, the pilgrimage to Mecca. Officially not a bank, that institution evolved into Lembaga Urusan Dan Tabung Haji (the Pilgrims' Management and Fund Board), which is known as Tabung Haji for short and is now one of the world's biggest Islamic institutions.
It is chiefly on the back of Tabung Haji's surplus Hinds sitting in interest-free-deposits that Malaysia is pursuing development of a dual Islamic-conventional financial system. Since 1983 Malay-controlled governments have pushed the experiment as a way to raise the living standards of the Malay majority in a country where the Chinese minority controls most of the wealth. That effort has put Malaysia way ahead of the rest of the Islamic world in product innovation. Gulf bankers snipe that Malaysia's interpretations of shari'a are too liberal. But they are gradually coming around. Kuwait is now studying the Malaysian dual banking model. And Bahrain, which has been losing some conventional banking business to Dubai, is welcoming its new Islamic banks.
Islamic finance remained minuscule until the 1970s, when a twelve fold increase in oil prices suddenly produced a great deal of excess wealth. Islamic banks began popping up in Dubai, Bahrain, Egypt, Sudan, and the Philippines, and the multilateral Islamic Development Bank was set up in Saudi Arabia. But many governments, leery of Islamic fundamentalist movements, have remained ambivalent about Islamic banks. Egypt's state-owned Islamic bank, Nasser Social Bank, conspicuously leaves the word "Islamic" out of its name, as does the Philippine Amanah Bank, which was established by presidential decree in 1973 to cater to the country's troublesome Muslim minority in the south.
When Saudi Arabia licensed a currency exchange company as its first (and only) Islamic bank in 1988, the company was required to drop the word "Islamic" so as not to draw attention to the fact that all of Saudi Arabia's other, banks deal in interest and are not Islamic. The Saudi government is also eager to retain its close financial ties to the West, especially since it is now a debtor country and must borrow on international markets. Meantime, Al-Rajhi Investment & Banking has become one of the world's largest repositories of Islamic assets. In secular Turkey, where fundamentalists have gained political strength, Islamic banks are officially called "special finance houses."
Country by country, Islamic finance is a crazy quilt industry. It is almost nonexistent in the Maghreb countries of Morocco, Algeria, and Tunisia, though DMI's banking arm, Faisal Islamic Bank, has established joint ventures in both Tunisia and Algeria. Egypt has yet to recover from a scandal several years ago, when a slew of Islamic financial institutions turned into pyramid schemes, collapsed, and burnt a lot of depositors, and Islamic finance is only just starring in Indonesia. Only Iran and Sudan have entirely Islamic banking systems. Pakistan is trying to have one, but according to Islamic Banking's Parker, Pakistani banks still do a lot of conventional business. Islamic banks also exist in such countries as Australia, Denmark, Switzerland, India, and Thailand as well as a slew of African nations, from Senegal and Guinea to South Africa. "We've done two Islamic deals in South Africa since January." says Klein won Benson's Cox—a $65 million trade financing and a $30 million oil purchase facility.
Islamic finance also suffers from a lack of consensus on how to interpret shari'a. Each financial institution and private investment group has its own board of shari'a experts, essentially religious accountants, and what is deemed acceptable can vary widely. Though some Gulf companies such as DMI's Faisal group, Bahrain's Alharaka Islamic Investment Bank, and Kuwait Finance House have established operations in other countries, there are few links from country to country. There are no coherent standards, of regulation and no bank of last resort. In countries (Malaysia being the most notable exception), central bankers are at a loss how to treat Islamic banks.
Mohsin Khan, deputy director of research at the Internalional Monetary Fund in Washington, ticks off the main questions: "Should Islamic banks be subject to reserve requirements similar to those of other banks? Are they inherently more or less risky than traditional banks? How can a central bank conduct open market operations with securities that don't pay an interest rate? These questions are extremely important to the efficient functioning of Islamic banking and need to be resolved."
Islamic banks are also handicapped by limits in their own operations. For instance, without much in the way of local money markets—much less an international interbank market—they have no way of obtaining or parking surplus funds overnight. "The only way banks get together is in syndications," says Shaukat Aziz, a former head of Saudi American Bank, Citibank's Saudi Arabian affiliate, who now heads Citibank's corporate planning in New York.
Malaysia started an Islamic interbank money market two years ago and has devised several short-term, debt-like instruments. But trading has not yet developed sufficiently to provide liquidity. "Instruments are being kept more as investments than being actively traded," says Jati Discounts' Wan Abdul Rahim Kamtl. His solution: more instruments. Bahrain is now trying to get an interbank market going, too. And United Bank of Kuwait is developing a short-term commodity contract that would trade on commodity exchanges. "It's not a futures contract as such," says Richard Thomas, head of investment at UBK's Islamic banking unit in London. "It should offer returns in line with conventional call rates."
Another difficulty is that Islamic banks have concentrated mostly on short-term financings. In their simplest form, Islamic banks offer two types of deposit accounts—transaction accounts, which pay no interest but provide conventional check clearing and other services (except for credit cards), and investment, or profit-and-loss, accounts, which pool deposits in a fund-like manner to engage in short-term trade and commodity financings and share the profits with depositors.
One of the main aims of the product innovators is to nudge Islamic banks and investors into longer-term risks. "As the market gets more competitive, the industry is forced to go toward project finance and corporate finance for higher spreads," notes al-Bahar. The chief stumbling block is that investors are chary of taking on long-term risks unless they can bail out when necessary. In short, Islamic finance desperately needs to securitize long-term investments and develop active secondary markets. Only then can it expand into such sophisticated activities as venture capital and management buyouts.
The new Islamic mutual funds may go a long way toward accustoming Islamic investors to securities trading. Kleinwort Benson launched the first opened Islamic equity fund in 1986. Sold mostly in the fund died a quick death after Iraq's invasion in 1990. Now Kleinwort Benson is taking a different act — an Islamic open-end fund chat will in base metals traded on the Metals Exchange.
More daring are the new equity funds. The International Investor, which already had a local Islamic fund, launched an emerging markets mutual fund last November that is already up about 11%. "We're now working on a global fund, to invest in the developed world," says Basil al-Ghalayini, who runs TII's London office and designs the funds. In February, the investment banking arm of Britain's Robert Fleming Holdings introduced an international equity fund, the first of a series of funds for Islamic investors under its umbrella Oasis Fund.
Making an equity fund acceptable under shari'a isn't easy. Islamic law does not permit investment in companies that mate money from alcohol, which eliminates not only brewers and vintners but also companies that own hotels and resorts and even airlines that sell drinks. The funds must also screen out tobacco companies, pork processors, arms makers, and gambling operations. Furthermore, to pass muster with shari'a experts, interest income earned by portfolio companies must be "purified." To do so, the fund must calculate its pro rata share of the companies' interest income and distribute that sum to designated charities. Finally, both the TII and Fleming funds screen out highly leveraged companies—in TII's case, that eliminates "anything beyond 33% leverage on paid-up capital," al-Ghalayini explains.
Inevitably, though, same compromises must be made. For example, what is to be done about a portfolio company's regular interest payments on loans for working capital and the like? Al-Ghalayini bridles at the question. "If you look at every aspect of their business, then you are left with nothing," he says. In short, better to have a "partially contaminated" product than none at all. That could prove to be the main issue underlying the development of new Islamic products. If Islamic finance is truly to link up with the global mainstream, shari'a boards may have to overlook a lot of such fine points. —Azhar Sukri contributed to this article from Kuala Lumpur.
An Islamic Way of Leverage
When it comes to stock market investments, correct Islamic Investors avoid shares in highly leveraged companies; interest payments are taboo. But when it comes to real estate, leveraging with a big chunk of debt is often the only way to make an investment profitable. Is there a way that Islamic property Investors can take advantage of leveraging—without committing riba?
There certainly is. The technique is to turn an outright purchase into a lease-purchase arrangement, called ijara wa'iqtina, by introducing a third party into the deal. Westerners are accustomed to thinking of the markup in installment payments as a hidden interest rate, but Muslims have no qualms about leasing or Installment deals.
King & Spalding, an Atlanta law firm that specializes in Islamic business, and Citibank recently arranged for a group of wealthy individuals from the Gulf to acquire a commercial US property. Nagib Baroudi of Citibank's private banking arm and Isam Salah, who runs the New York end of King & Spalding's Islamic practice, explain how the structure works.
The first step, says Baroudi, is to "create a vehicle not immediately owned by the Investor." The trick is to set up a special purpose vehicle (SPV) that is tax-neutral and owned by a charitable trust—a technique borrowed from the securitization of such assets as credit card and auto loan receivables. The investor puts 30-40% of the purchase price into the SPV, while the bank puts in 60-70% in the form of medium-term financings.
The SPV becomes the official owner of the property, then grants a medium-term head lease to the investor, who is officially a tenant. The terms of the lease, however, give the investor the right to collect rents from sub-lessees and requires the investor to run the property as if he were the owner. The investor then makes payments from the rental stream, usually quarterly, to cover the SPV's expenses, including its interest costs. Typically, the lease payments are low enough to provide an ongoing return to the investor; the bulk of the purchase price is paid at the end of the lease—whereupon the investor now owns the property.
A prime objective, Salah says, is to "try to mirror the tax treatment that a conventional equity Investor would get and to give the Islamic investor the same rights and benefits." The key factor is that the terms of the lease allow US tax authorities to treat the Investor as the effective owner and thus able to deduct a portion of the lease payments as if it were interest. Yes, the whole arrangement is complex. But, Salah notes, "Islamic Investors have become more willing to look at complex structures."
—Bill Shepherd
What Exactly is Riba?
The biggest issue keeping Islamic finance out of the global financial system— and dividing Muslims themselves—is the matter of riba. Muhammad made it clear that riba is to be avoided at all cost. But he didn't make it clear just what riba is. According to one of his companions, "the last verse to be revealed was on riba, and the prophet passed away without explaining it to us."
Some Westerners mistakenly believe the word riba is derived from the Arabic root rbh, which means to profit or gain. But Islam is not against profit; Muhammad himself was a merchant and trader (which is why the Koran, unlike the Jewish or Christian Bible, is much concerned with fair business dealings). Rather, riba is believed to derive from rbw, a root that means to increase or grow—but that carries a sense of helping something grow organically, from within. Words for breeding animals and rearing and educating children spring from the same root.
The Koran includes four different revelations touching on riba. The first distinguishes riba, which wins no points with God, from charity, which does. The second puts riba in the same category as wrongful appropriation of other people's property and states that God will punish it. The third is the clearest: It commands believers not to take "doubled and redoubled riba" for fear of the fire prepared for those who reject faith. It refers to a widespread practice among lenders in Muhammad's time of doubling the amount owed when a borrower was late with a payment—and doubling it again if the borrower still didn't pay. The last revelation distinguishes riba from trade, which is permitted, and warns that "those who devour riba" will abide in the fire forever.
On the strength of the third revelation, many Muslims argue that riba means only exorbitant interest, or usury. Some speculate that the word is actually derived from rb', the root for galloping, quadrupling, multiplying by four. The flaw in this argument is simple enough: The qualifiers "doubled" and "redoubled" would not have been necessary if the word already meant that.
The hadith, or secondhand reports of Muhammad's and others' comments, are marginally more helpful. Some might refer to interest, some obviously don't, and some are ambiguous. "One who serves as an agent to bid up the price in an auction is a cursed taker of riba" has nothing to do with interest. In the most famous hadith Muhammad states that exchanges of "gold for gold, sliver for silver, wheat for wheat, barley for barley, dates for dates, salt for salt must be of equivalent weight." In another a man exchanges two measures of inferior dates for one of good dates-"This is exactly riba," said the prophet. But what exactly?
On these slim clues Islamic scholars have produced mountains of exegesis. For convenience, most Muslims take riba to mean interest, or the making of money with money. In one hadith a lender named Umar refuses a gift of dates when his money is returned on grounds that an increase in payment because of delay is riba. But another, in which Muhammad says "riba is verily in deferred payment," has apparently been ignored by most scholars, who hold that deferred payment with a markup is okay.
In a general sense riba is obviously more than interest—it is unfairness in transactions, whether in loans or in commerce. A more specific meaning is impossible to pin down. "I've worked in the market 14 years, and I can't define it," says Richard Duncan, director of Islamic finance at ANZ International Merchant Banking in London. "You define the term with the customer. Each Investor must stand before God alone."
—Bill Shepherd
