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Wednesday, August 13, 2008

Islamic finance: loophole in faith

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As part of a research paper, I studied what Islamic finance is all about. Since I didn't know anything about the subject before, outcome was very surprising and interesting. Islamic finance, or Shariah banking, is banking and investing with rules that are compliant with Kuran. And Kuran doesn't like that people:

  1. collect interest since earning money on money is bad
  2. earn reward without sharing risk
  3. invest in businesses which are haraam such as those dealing with alcohol, pork, gambling, interest collection, entertainment, tobacco, fashion, pornography and weapon
  4. invest in businesses which earn or pay interest or earn money from largely liquid assets (aka money)

Kuran, though, permits trade and selling something for profit and charging rent for use of property. In light of this all but point 3 are just contradictory to say the least. When I can charge rent for you using a car, how is charging rent (commonly known as interest) on you using money from which you can buy car any different? After all, both car and money have utility to me that I forgo when I rent them to you? Similarly, when a bank gives loan to a business and seeks interest in return, it is not exactly seeking return without sharing the risk of business failure as Kuran seems to suggest. When business defaults so bank too loses its debt and hence is sharing part of the risk. Last point is corollary to first point, just from the point of view of company.

But since faith doesn't accept logical explanations, and Muslims are practical people living in practical world, they've come up with some "loopholes" to abide by Kuran and at the same time use regular financial services. Now with oil-money pumping out of Middle East and a quarter of world's population being Muslim, there is huge market for Islamic products which is estimated to be about $300-$500 billion growing annually at 20%. Therefore, many banks and stock markets are creating investment funds to abide by these rules.

So, say you want to buy a car from Islamic bank. Instead of (1) borrowing money, (2) buying car yourself, and (3) paying back interest, you would (1) ask bank to buy car for you and (2) sell to you at higher price making a profit and then (3) you just pay back purchase price to bank which doesn't include interest but only profit margin. Alternative is that (1) bank buys for you, (2) rents car to you and (3) you pay back original purchase price to bank in installments without interest or profit margin, but (4) also pay rent for use during some predefined period.

And if your firm wants to borrow from bank, you will (1) pay back loan amount without interest but (2) also pay back some part of profit or loss of firm for stipulated time. In essence, banks becomes equity holder rather than just debt holder. Of course, when sharing larger risk as equity holder bank charges larger return in form of profit/loss margin, but at least Kuran is followed.

Mutual fund which are Shariah-compliant work by excluding all socially-harmful firms from investing universe. Among the remaining, nearly every firm invests its cash in interest bearing assets (earn interest) or borrows from banks (pay interest) and has some of its assets in liquid form (cash, short-term securities). After long hours of brainstorming about managing a workaround with rule 4 above, Islamic scholars have come up with idea that as long as interest income is less than one-third of total income and liquid assets less than one-third of total assets, Allah shall forgive. However, interest income has to be purified by donating that part to charities.

Considering the demand for these products, lots of Indian banks (Kotak Mahindra, Reliance, UTI, Edelweiss) are jumping into bandwagon to launch these products. Finally all is well with world and Muslims are using financial services in accordance with highest law on earth.

Full report can be downloaded from esnips.com or read at scribd.com.

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