Islamic Finance is Growing Fast but Faces the Form-Versus-Substance Debate

Ibrahim Warde, adjunct professor of international business at the Fletcher School of Law and Diplomacy at Tufts University

Speaking at the Fourth Annual CFA Institute Middle East Investment Conference in Dubai, Ibrahim Warde, adjunct professor at Tufts University in the United States and a noted author on Islamic finance, argued that since the 1990s, Islamic finance has gained much more international acceptability but that it continues to grapple with the fundamental form-versus-substance debate.

With the current size of the Islamic finance market at over 1.3 trillion U.S. dollars, Warde believes “it is not an exaggeration to say that in the world of finance, the fastest growing segment is Islamic finance.” The data he shared showed that assets of the Islamic financial sector grew by 21% in 2006, 29% in 2007, 16% in 2008, 18% in 2009, 22% in 2010, 20% in 2011, and an estimated 24% in 2012. He said that in some markets, such as Malaysia, Islamic finance has appeal beyond Muslims; many non-Muslim Malaysians, of Chinese and Indian origin, are both customers and staff of Malaysian Islamic financial institutions.

Historically, Warde explained, religion has had much to do with finance, and all three Abrahamic faiths — Judaism, Christianity, and Islam — have had somewhat similar teachings on finance. Also, some secular perspectives, such as that of Aristotle, have also considered money to be sterile and “making money from money” (that is, without asset and enterprise) as problematic. He was of the view that in the heyday of conventional finance, prior to the financial crisis, ideas such as the role of religion in finance and any alternative financial system were considered needless. He added that the crisis has exposed the weaknesses of the current financial system and there has been “public outrage over excesses and support for more conservative and ethical finance.”

Warde mentioned that the Islamic prohibition of riba (or usury) has counterparts in other religions, but the prohibition of gharar, usually translated as excessive risk or uncertainty in financial transactions, is exclusive to Islam. He was of the view that the concept of gharar should also be interpreted in the context of problems created by asymmetrical information, such as is explained in the lemon market theory. According to this theory, sellers (say of used cars) who have more information about the quality of the goods being sold have an unfair advantage over less informed buyers, which in turn, affects the whole market. This was seen in the financial crisis when better informed investment banks reportedly sold “toxic assets” to less informed pension funds, which negatively affected the entire market.

From a political and economic perspective, Warde divided the history of modern Islamic finance into three stages: the period from 1975 to 1991, characterised by renewed interest in Islamic economic thought and finance; the period from 1991 to 2001, characterised by trials and errors turning theory into practice; and post-2001, characterised by a boom, greater coherence in Islamic finance across countries, and more international financial institutions offering Islamic financial services.

He argued that a selling point of Islamic finance is that profit maximisation should not be the only objective of financial institutions and that offering social value should be a part of the value proposition. He added that Islamic finance had a “lofty ambition” to be an alternative financial system but it has made compromises on high ideals after the initial stumbles. It was intended to be mudaraba (or investment management) based equity financing, whereas in practice it is largely murabaha (or sale at a disclosed profit) based debt financing — “Islamising” conventional finance rather than offering a complete alternative. On the one hand, the compromises have enabled Islamic finance to survive in a world dominated by conventional finance, but on the other hand, it has not been able to live up to its ambition.

He explained that the fundamental debate within Islamic finance is the form-versus-substance debate and that critics, such as Mahmoud El-Gamal, continue to assail the industry for “rent-seeking shari’a arbitrage.” These critics argue that in modern Islamic finance, conventional financial products can be sold at a higher price if their legal form is changed to comply with Islamic law. However, their economic substance is retained, which circumvents the Islamic prohibitions of riba and gharar and defeats the objectives of the Islamic law.

In the context of the Arab Spring, Warde was of the view that Islamic finance is “one of the main economic beneficiaries.” Suppressed Islamic movements are in power in some of the Arab countries, and new legislation is being passed or discussed by legislators in different countries in the Middle East and North Africa (MENA) region to broaden its scope, such as for issuing sukuk. He thinks that Islamic finance is “fertile ground for compromise” between the religiously conservative and the secular in countries like Tunisia. He added that in those countries trying to preempt revolutionary change, such as Morocco, Jordan, and the Gulf states, “Islamic finance is a significant part of reform.”

Warde highlighted that in recent weeks there have been a number of significant developments in Islamic finance. These include the ruler of Dubai announcing that Dubai is to become the center of Islamic finance; the British government establishing a task force on Islamic finance; governments in Ireland, Bermuda, South Africa, Nigeria, and Senegal affirming their commitment to Islamic finance; Kingdom Holding, the international investment firm of Saudi billionaire Prince Alwaleed bin Talal, forming a shari’a board; the Qatar finance minister confirming it would soon establish a major international Islamic bank; and the sukuk market expanding rapidly.

Warde supported creating a favourable climate for entrepreneurship in MENA. He said that financing entrepreneurs in MENA need not only be based on mudaraba and that it is unsuitable for commercial banks, including Islamic commercial banks, to deal with depositors’ money, given that so many new businesses fail. He recommended Islamically acceptable public–private partnerships, which would allow Silicon Valley–style venture capital to finance MENA’s entrepreneurs.

To conclude, Warde provided a positive outlook for Islamic finance but cautioned against complacency. There are risks inherent in rapid growth and euphoria in Islamic finance, like euphoria elsewhere, and these are likely to lead to bubbles, he warned.

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