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On the 31st of January of this year I attended a conference on Islamic banking and finance organised by Euromoney in London. In answer to a question from the floor, one of the scholarly panelists remarked that "we welcome constructive comments, but there are some people who only wish to be destructive and we ignore them". Later he asked "are Muslims not in need of home financing or car financing?" with the obvious implication that his critics think they are not.

Intentional or otherwise, this was a misrepresentation of the arguments that the inner circle of Islamic finance scholars face. And while each of us is entitled to develop his own economic theory, once the "Islamic" label is used the views of other professionals should not be dismissed too lightly. Islamic banking and finance is not a football that can be monopolised in the school playground. It is not an intellectual pet that belongs to any one group of people.

Because most of the world now sees usury as something normal, perhaps even necessary, Islam has become the last remaining line of defence among those religions and ideologies that once prohibited it. If the Muslims fail to promote a truly usury-free approach in finance, few others will do so. Unfortunately, in our rush to embrace the world of secular business and politics, vital matters of Islamic law and institutional substance have been passed over with almost casual arrogance. What makes this so dangerous is that business and politics are two of the least desirable forces for shaping the laws and institutions of a nation. It was their union that gave birth to the modern interest-based monetary system in London some three hundred years ago. William of Orange wanted power, the money lenders wanted a banking monopoly, and their creation was called the Bank of England.

Undoubtedly, powerful forces are now at work that seek to overturn the Islamic prohibition of usury. In many cases their tactics are identical to those that were deployed in Christendom. In the late Middle Ages and early Renaissance, the Scholastics argued against "retrovenditio" (known in Islam as bay al-`ina). They prohibited the exchange of a bottle of wine now for a bottle of the same wine several months later (a practice that has much in common with riba al-nasa) because wine became more valuable as it matured. Such contracts were recognised as covert forms of usury by the Church scholars, but it was the construction of a usurious loan through the combination of three permissible contracts (the "Contractum Trinius") that finally defeated them. Here was the door through which money lending at interest entered the daily practice of merchants in the Christian world, just as the practice of "murabahah-to-the-purchase-orderer" has done in the Islamic world.

The famous chronicler Matthew Paris describes a contract document from the year 1235CE, in which the bishops of the day had found a way of borrowing money at usury whilst keeping the appearance of staying within the Biblical law. Of the money lenders who were lending to the bishops, Paris writes: "... they circumvented the needy in their necessities, cloaking their usuries under the show of trade, and pretending not to know that whatever is added to the principal is usury by whatever name it is called". Cloaking their usuries under the show of trade? How depressingly familiar.

A few years ago, one occassionally heard scholars mentioning Michael Rowbotham on the subject of money creation by the commercial banking system. Although he does not believe that interest should be prohibited, the prominence of Michael's work was a hopeful sign because his thesis on the monetary system is essentially correct. Like me he believes that the business model of commercial banking involves the creation of money out of nothing (fraud) and its subsequent lending at interest (riba). For Muslims to focus on narrow issues of contractual structure when the monetary framework has been corrupted in this manner, is to guarantee the failure of the Islamic finance experiment. Islamic finance cannot succeed with un-Islamic money.

A key point in this connection is that no one, neither an individual nor a financial institution, should give a promise that is impossible to keep. If a bank promises to pay £100 in cash to a customer on demand, then the bank should keep £100 in cash in order to fulfil that promise when the customer requires it. This of course is not the case in modern commercial banking. For example, HSBC’s 2006 Annual Report shows that its customers held in aggregate some £150 billion of sight deposits, yet at the same time HSBC held only £3.5 billion of cash to honour requests for withdrawal of those deposits. If all of HSBC’s customers asked for their money in cash on the same day, HSBC would be forced to close its doors.

This practice of holding a fractional reserve is a classic case of gharar. It is also the misrepresentation that lies at the core of commercial banking. By lending out money that they are supposed to be holding for sight depositors, commercial banks increase the money supply. In the process they also increase their interest revenue, which is of course the point of the whole exercise. Inflation, indebtedness and the forced economic growth that Michael Rowbotham speaks of, become features of our economic landscape as a consequence of this practice.

In the West, the longstanding policy has been to regulate rather than abandon the fractional reserve system. Since commercial banks practice gharar by holding insufficient reserves to redeem their deposit liabilities, central banks offer a "lender of last resort" function in order to make extra reserves available to them in times of need. And since banks practice riba by promising in advance to pay depositors a percentage gain on their deposits, come what may, they must adhere to capital adequacy ratios. These require that each bank holds a cushion of capital to protect depositors from poor performance of the bank’s loan book.

The briefest of consideration would inform us that the lender of last resort function and the capital adequacy ratio, like many other features of the modern banking landscape, are a consequence of not implementing Shari`ah. This is why it is so utterly depressing to find Muslim executives and academics proclaiming the need for these very practices within an Islamic banking system. At the London conference, proud announcements were made of progress towards an "Islamic debt market", "adoption of the Bank for International Settlements framework" and "closer ties with the International Capital Markets Association". Our leaders do not seem to see that the structures with which they are trying to integrate could only grow in the soil of usury. Attempting to invent their Islamic equivalent is just as unreasonable as attempting the creation of an Islamic thief. Can we not have the vision to grow our own tree, in the soil of Islam, and harvest the pleasant fruit that would undoubtedly grow on it?

The impact of the interest-based money creation framework on the property market is well known in many countries. In the United Kingdom in 1963 the average house price was £3,160. Ten years later it was £9,942, ten years after that £26,471, and today it is some £200,000. Trying to save for a house under these circumstances is impossible for all but the highest earners in society. For the rest of us, by the time we have reached our savings target, the price of the house has doubled or trebled. The only practical option in these circumstances is to borrow the money in order to buy the house. But money borrowed from the bank is newly created money, and when that money is injected into the housing market, house prices rise. The act that allows one person to buy a house, causes house prices to become unaffordable for the next person. This is an awful trap, one that "Islamic" mortgages do nothing to solve because the banks that offer them are also creating money out of nothing. By promoting Islamic mortgages as a solution to our home financing needs, our problems only worsen in the long run.

In the model of home finance that I have promoted over the last decade or so, the financier buys a proportion of a property and the client buys the remainder. These two parties own the property as partners, and subsequently rent it to a tenant. The tenant in most cases is the home buying client. Over the years, the client can buy the financier’s share of the property, and if he does so he pays the market price for the share he buys. But the client doesn’t have to buy the financier’s share, and this is a vital feature because it means that the client is not in debt to the financier. At the end of the partnership term, if the client has not bought all of the financier’s share, the house will be sold on the open market and the sale proceeds will be divided between the partners according to the ratio of their partnership shares at that time. In this structure, the client can never be repossessed by the financier because he is never in debt to the financier. Neither can he find himself in "negative equity", the position that often occurs in interest-based mortgages where the debt owed on a property is greater than the value of the property. If the financier owns 80% of a property and the property falls in value to nothing, then the financier owns 80% of nothing and the client does not need to compensate him with a single penny.

Imagine if such a product existed in a Western country today. If the people of Britain or America knew that there was a way of buying a home and not being in debt, millions of them would go for it. And if they saw that it was the Muslims who were providing them with that solution, they would surely think more highly of Islam. Yet in almost every "Islamic" mortgage product available today, capital risk is shifted from the bank to the customer just as in a interest-based loan. The customer is in debt to the bank, just as in an interest-based loan. The monthly cash-flows are the same or higher than an interest-based loan. In many cases the rental rate can rise as unpredictably as the interest charge on a variable rate mortgage, because it is linked to LIBOR. And in a default, the customer may find himself in a position of negative equity, just as in an interest-based loan. Is it any surprise that non-Muslims who hear of the principles of Shari`ah, and are then confronted with its implementation, should mock us for what is happening?

So I do believe that Muslims need home finance. It’s just that my way of doing it accords with the spirit and tradition of our religion, while the ways of Islamic banking usually don’t. And I am not alone in my feelings. I speak to many financial executives who are equally disillusioned. Their feelings include guilt ("I feel like I just participated in the Manhattan Project and regret what I have helped to create"), derision ("... these instruments are pretty much a sham, and I still cannot believe that eminent scholars passed this product as Shari`ah compliant") and hostility ("... the more I practice Islamic finance, the more I hate it"). When practitioners within the industry make comments such as these, they cannot just be ignored. There is clearly a fundamental problem.

It is well known that Islamic banks cannot charge interest on a late payment of an installment due under a murabahah contract. We also know that tawarruq financing has been allowed by some scholars. Here, the client buys a commodity for delivery now against deferred payment, then sells the commodity into the market at a lower price for immediate cash payment. The bank arranges both transactions using various commodity dealers, and in this way maintains the fiction that it is trading commodities with its client. The substance of the transaction, of course, is that the client is borrowing money at interest from the bank. But to allow tawarruq and simultaneously prohibit the charging of a penalty for late payment of a debt is pointless in every sense and here is why, in the words of an Islamic banking lawyer: "We were told that banks couldn’t charge an interest penalty in event of late payment by the client. So we re-financed a late murabahah installment by entering into a tawarruq contract with the client. In that way the bank received its interest penalty, in effect".

Most of these practices rely heavily on the legal device of contract combination. A loan, a promise and a gift are each halal from the perspective of Shari`ah, yet their combination easily produces a "money-now for more-money-later" transaction. No scholar would permit such a transaction, yet the combination of two halal transactions produces precisely the same result in "murabahah-to-the-purchase-orderer". Why is the first combination seen as a form of riba, and the second not?

If the spirit of Shari`ah is being broken by means of contract combination, then so too is the letter of the law being broken by the practice of "benchmarking". In many modern lease contracts, the rental rate charged to the tenant is linked to LIBOR. Since LIBOR for any given period is not known until the commencement of that period, the tenant in a property cannot know what rent he will have to pay for its use in future periods. Rentals may therefore increase substantially and unexpectedly if market interest rates rise and, for many holders of Islamic mortgages, an increase of two or three percent can make the monthly payments unaffordable. There is an overwhelming consensus in Shari`ah that the price of an object of sale should be known at the time of contract signing, and rent is of course a price that is paid for the right to use a property. Yet this fundamental requirement is contradicted by linking rental payments to future measures of LIBOR. Clearly, many banks want to promote LIBOR linking in Islamic finance because the funds they use to finance their customers are themselves borrowed at an interest rate that is linked to LIBOR. Is it not therefore obvious that if the banks have financed themselves at interest, then the funds obtained thereby must be deployed in a way that mimics an interest-based loan? Wasn’t Islamic banking meant to challenge the interest-based model, rather than integrate into it?

And what of the forward sale of partnership shares? Let us imagine that two partners establish a business with contributions of 50 each in capital. These two partners share the profits in any way that they choose, and share losses in accordance with their share of the capital. It is therefore not permitted to agree at the outset that one partner will buy the other’s share, say at a price of 60 in one year’s time, since this would contractually guarantee a profit of 10 to the partner who sells his shares. Recent AAOIFI standards (3/1/6/2, 2003-2004) echo this point, but things are very different in practice.

For example, a forward sale of partnership shares was agreed in the USD3.5 billion sukuk issued by PCFC in UAE during 2006. The sukuk documentation requires that one musharakah partner buys the other’s share at a price that provides a pre-agreed gain of up to 10.125% per year. There are several clauses in the PCFC prospectus that achieve this, though one needs a forensic ability to identify them:
"The Obligor shall execute a purchase undertaking (the Purchase Undertaking) in favour of the Issuer. Pursuant to the Purchase Undertaking, the Obligor shall undertake to purchase the Issuer’s Units at the Relevant Exercise Price";
"Relevant Exercise Price means ... a US Dollar amount equal to the aggregate of (i) the Outstanding Sukuk Amount and (ii) the Scheduled Accumulated Sukuk Return Amount";
"Scheduled Accumulated Sukuk Return Amount means an amount calculated as follows: Scheduled Accumulated Sukuk Return Amount = Outstanding Sukuk Amount x 10.125% x (n/360) where: n means the number of days for the period ..."
PCFC Development FCZO, Offering Circular, January 2006

Is this not a shallow subterfuge in violation of industry standards? Certainly the terminology is typical of an interest-bearing bond, fixing in advance a positive return for investors in the sukuk. Yet look how it is portrayed by an executive at Dubai Islamic Bank:
"Many readers may have been wondering as to how the PCFC Sukuk carries a pre-known profit rate whereas the Islamic Sharia is averse to the idea of fixing a return on investment at the outset. In order to substantiate that for all practical purposes, the above is a projected return based on a business plan prepared and submitted by PCFC to the investors, I would like to quote the gist of a relevant clause from the Musharaka agreement entered into between PCFC and the Special Purpose Co (SPC) representing scores of investors in the Sukuk: ‘PCFC acknowledges that it has prepared the business plan based on which the Musharaka is expected to yield a minimum profit of (say 15 per cent) per annum on its total equity. The Musharaka profit will be distributed between PCFC and the investors at the ratio of 30:70 respectively.’ "

Nowhere in the above explanation does the fact of a purchase undertaking appear, something that is central to the PCFC structure. What do the profit-sharing arrangements matter, if one partner has undertaken to purchase the other’s share for a 10.125% profit on maturity?

If it becomes our culture to turn a blind eye to these various goings-on, then it will be more than just our jurisprudence that suffers. If Shari`ah violation is off-limits as a subject of discussion, why should the commercial performance of Islamic financial products come under any greater scrutiny? In all of the marketing buzz surrounding PCFC, for example, few people have asked why a government guaranteed organisation in the UAE should be raising funds at a pre-agreed financing cost that is several hundred basis points above US dollar LIBOR. If one is going to agree a financing cost on money at the outset, why not borrow at LIBOR instead and save tens of millions of dollars in the process? As another example, whilst researching for a client recently, I came across a fund that won the second place prize at an award ceremony in Saudi Arabia a couple of years ago. The fund focussed on North American equities and had lost some 16% of its value since inception, after fees. Over the same period, the market as a whole had risen by 3.3%. On average, initial investors in the fund would have done better by choosing their portfolio components at random from the Dow Jones Islamic Index.

An honest discussion of issues such as these is central to the long term credibility of the Islamic finance industry, but instead we get empty hype and a refusal to engage on the key topics. There has been a deliberate weeding out of traditionalists and plain speakers, with the result that too many of the people promoted to the conference platform are long on compromise or short on vision. All of this has been substantially encouraged by the secular banking lobby. It is they who are making a trillion dollars or more every year from the practice of usury. Why would they ever promote an industry that seeks to abolish it? And shouldn’t we be slightly concerned that so many of our leading scholars have achieved prominence through the patronage of these institutions?

Consider the consequences if we fail to defeat usury. The business model of many modern corporations is to borrow money from the bank at interest and then to invest that money into corporate operations yielding a higher rate of return on assets. Under this model, the more the firm borrows, the more profit it makes. So if the interest rate is 5% and the return on assets 20% then, for every extra dollar borrowed, another 15 cents in profit is generated. Firms therefore compete to borrow very large amounts of money from the banks, which as we know can create it out of nothing almost ad infinitum. Those that are able to borrow the most swallow up business opportunities that would otherwise have gone to smaller firms. The results of this can be seen everywhere. In the production process, owner-managers become disinterested lower-paid employees. In our landscape, characterful villages are encircled by anonymous housing estates and massive sheds. In our environment, intensive production puts stress on natural resources. And in countless communities, local influence over local affairs declines, as centres of control move to headquarters that are often thousands of miles away. These are some of the monuments to modern leverage.

In the Muslim world, leverage has traditionally been hard to achieve. If one cannot borrow at interest then how can one generate that 15 cents of profit on every dollar? If funds were raised on a profit-sharing basis, the entrepreneur would have to share the 15 cents with the investor and this would change the nature of financing activity entirely. The financier’s motive would be to choose the most profitable projects available, not necessarily the biggest ones. And since financiers could not charge interest, they would no longer be so concerned about the amount of collateral possessed by their clients. Under profit-sharing, what matters most to financiers is that their clients should have good management and profitable business opportunities. It is a system in which wealth begins to circulate among the poor once again, since profitable ideas and good management are not the sole privilege of the rich. Regrettably, in the Middle East today, debt financed mega-projects are announced on a regular basis. The marketing literature assumes that we will be proud of these projects, when in fact it is shameful that such huge resources are being centralised in the hands of so few people and organisations. Communities build societies, bankers and leverage don’t.

I know of many dedicated people who joined the Islamic finance movement in the hope that it would help to relieve the injustice of debt. But they have become mere tools by which debt can be spread more widely. Decades of marketing failed to convince the people of Saudi Arabia to borrow at interest. Tawarruq has achieved it in a couple of years. That is the legacy of modern Islamic banking and finance, and the interest-based establishment is laughing at us for having let it happen so easily. What good is our Shari`ah if it becomes a commodity for sale to usurers? Or if we exempt ourselves from its rules, in ignorance of their wisdom?

We believe that falsehood always destroys itself eventually. The Western financial system is no exception to this rule, and neither is our present "Islamic" banking system. If we had adopted a banking and finance strategy worthy of the word "Islamic", then in financial crises to come we could have demonstrated the superiority of our banking and finance model to the whole world. But we have adopted the interest-based system as our template, and so that opportunity has already been lost. Come the day, the Islamic banking system will be in just as much of a mess as its Western counterpart, its legal tricks swept away on a tide of financial distress, and I may just laugh more than I cry.

Editorial, July 2007