The 2016 CFA Institute Middle East Investment Conference will take place in Bahrain on 13 April 2016, bringing together international thought leaders, policymakers, industry experts and key market participants from across the region to consider MENA’s Role in the Global Economy.
There is much potential for Islamic finance to promote sustainable economic development through such approaches as widening access to finance (including microfinance), financing infrastructure projects, and expanding the reach of takaful (Islamic insurance). This was the view expressed by the economist Volker Nienhaus while speaking at the 2014 CFA Institute Middle East Investment Conference. Nienhaus, who has a long-standing interest and experience in Islamic finance, emphasized that, unlike conventional finance, the Islamic finance industry is faith-based finance, and it is not expected to be purely commercial but to also serve a social purpose.
At the start of Nienhaus’s session, CFA Institute conducted an electronic poll of the conference delegates. We asked them which of the approaches to be covered by Nienhaus represented the best opportunity for Islamic finance to contribute to sustainable economic development. Of the nearly 300 people present, 156 participated in the instant poll, and they voted in favor of financing infrastructure (44%), followed by widening access to finance (35%).
Riba versus Interest
Nienhaus addressed a fundamental confusion in Islamic finance — whether all forms of economic interest are riba (loosely translated as usury), which is prohibited by the Quran. He explained that nominate contracts being used in contemporary Islamic finance (e.g., murabaha, or deferred payment trust sale) are functional equivalents of interest-bearing monetary loans.
Using this contract, the financier sells an asset to the client on credit, rather than extending a loan to buy the asset, and the credit price is more than the spot price. From an economic perspective, one may see such a transaction as a loan bundled with a sale of an asset and classify the difference between spot and credit price as implied interest. From the perspective of Islamic commercial jurisprudence, however, one may classify this as a sale with profit because the contract is one of sale and not that of a loan.
Nienhaus clarified that the contracts currently being used in Islamic finance are modified versions of classic nominate contracts found in Islamic commercial jurisprudence. It is, however, pertinent to note that classic contracts — such as those of sale and lease, which are widely used in Islamic commercial banking — were meant for trading, and these have been modified for financing in the modern banking environment.
History of Theory of Modern Islamic Finance
Nienhaus traced the origin of modern Islamic finance to the 1940s, particularly to the creation of Pakistan in 1947, at the end of British colonial rule of India. The idea back then, explained Nienhaus, was to have a system that was “neither the British style of colonial capitalism nor the Soviet style of state planning.” Those working on the theory of Islamic finance believed that an economy mainly financed by profit-sharing arrangements rather than interest-bearing loans would be more just and stable — and, of course, consistent with Islamic economic thought.
But over time, the practice of Islamic finance focused on Shari’a compliant debt at the micro (or transaction) level rather than moving away from interest-bearing loans at the macro (or system-wide) level. He clarified that avoiding interest-bearing loans does not automatically mean going for profit-and-loss-sharing arrangements. The mainstream view in Islamic finance industry is that debt created through a credit sale or operating lease, using the nominate contracts, does not fall within the scope of prohibition of riba.
Size and Composition of Industry
Nienhaus shared data on domicile of Islamic banking assets:
- Iran: 38%
- Saudi Arabia: 10%
- Malaysia: 10%
- United Arab Emirates: 7%
- Kuwait: 6%
- Qatar: 4%
- Others: 25%
He also shared breakdown of Islamic finance assets by the different segments. The data highlighted the fact that Islamic finance is best known for a fast pace of growth rather than size.
Sources: IFSB, Islamic Financial Services Industry Stability Report 2014 (forthcoming, data provided by KFH Research).
Questions and Answers
After about 20 minutes of Nienhaus’s presentation, there was an active question and answer session for another 20 minutes. Many of the questions were candid, if not provocative, and the chair of the conference, Raghida Dergham, founder and executive chairman of the Beirut Institute, skillfully managed to address some of these questions to Nienhaus within the time constraint.
Addressing the question if some methods of Islamic finance (e.g., credit sale) differ from their conventional equivalents only in semantics, Nienhaus said that in such cases, differences are legal in nature (e.g., contract of loan versus sale) and the implications fully come into play when things go wrong (e.g., defaults), and disputes have to be decided according to the governing law.
Commenting on the divergence between theory and practice, Nienhaus said that Islamic finance is meant to be inherently more ethical because of the sharing of risk by the contracting parties. In practice, however, instead of risk sharing, which is best accomplished by investment contracts, most of the financing is debt based.
Nienhaus thinks that perhaps we are expecting too much from Islamic commercial banks, which currently account for most Islamic finance assets. Islamic finance is not meant to be confined to commercial banking, and there is more room for both existing and potentially innovative types of non-banking financial institutions. These non-bank institutions should not take deposits at the retail level and offer financing based on genuine risk–reward sharing to converge theory and practice.
Nienhaus was asked if the late Ahmad El Najjar, the pioneer of modern Islamic finance, who experimented with Islamic community banking in Egypt in 1960s without using the “Islamic” label, would be proud of modern Islamic finance. Nienhaus, who happens to be a long-time friend of El Najjar’s family, candidly said that El Najjar was critical of some aspects of Islamic banking during his own time, and his critical views would definitely not have changed now.
Nienhaus concluded that if you take a purely legalistic view on Islamic finance, you can confine yourself to replicating commercial finance for the sole pursuit of profit. But Islamic finance is faith-based finance, and many expect it to also serve a social purpose and a role in sustainable economic development.
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