Could Islamic financing avoid credit crises?

Could Islamic Finance avoid credit crises?

Suppose for a moment all those sub-prime mortgages defaulting in the US weren’t based on cheap credit and were instead tied to real assets. True, there probably wouldn’t have been as many mortgages taken out, but then again, banks wouldn’t have as many to write down either.

Of course, this is not what happened, but perhaps it is a good time to look at the ancient guidelines for ethical finance. Although, not totally unique to Islamic thought, it is here that the idea has experienced a particular resurgence in recent years.

Strict Islamic banking and finance must adhere to the tenants of Sharia law, or Islamic jurisprudence. Sharia law prohibits the payment or earning of interest, speculation, contractual uncertainty, and transactions which are overly advantageous to one party at the expense of another. It also forbids investment in goods deemed harmful to the good of society such as gambling, pork, pornography, tobacco and alcohol.

Among the most significant and important differences between modern finance and Islamic finance is the prohibition of interest, or usury, because it is earning money without having to do any work for it. Needless to say, this is a stark contrast to modern finance in which interest is one of the key methods by which banks make money through their products such as mortgages and personal loans. Emphasised instead is profit and loss sharing between parties.

Christianity and Judaism have both historically opposed interest as sinful at some point, though the conviction was seldom adhered to. Even Aristotle felt that making money from money was ‘unnatural’ wealth creation, and St. Thomas Aquinas considered it ‘double charging’.

Similarly to Aristotle, Sharia considers interest unethical because it is a form of wealth creation which has no basis, creating a ‘virtual’ economy as opposed to a ‘real’ economy. Simplistically stated, interest generates money from money and trading in indebtedness as opposed to real tangible assets.

According to Kamal Mian, Associate Director of HSBC’s Islamic financing branch, Amanah, in 1996 the global financial derivatives market was estimated to be worth around £64 trillion. However, at the same time, the combined GDP of all countries in the world amounted to about £30 trillion.

This means that £34 trillion of the financial economy was linked to ‘virtual’, intangible assets, namely, credit – essentially, money that exists only because some one has declared that it will exist in the future.

This creates an economic problem which leads to bubbles and market falls: as interest increases the cost of an asset on the basis of credit, demand falls, if demand falls, then supply must also fall, if supply falls then productivity must fall as well which then results in unemployment and labour problems.

So how to tackle the ethical concerns in a financial economy largely dependent on interest-bearing products? In an Islamic mortgage transaction, instead of loaning the buyer money to purchase an item, a bank would buy the item itself from the seller at market, and re-sell it to the buyer at a profit, while allowing the buyer to pay the bank in instalments for rent and shares of ownership. In order to protect itself against default, the bank asks for strict collateral, and the goods or land is registered to the name of the buyer from the start of the transaction. Furthermore, the buyer must ensure the source of the money used by the bank to buy the property is also free of usury.

Islamic banks, then, avoid usury by making sure that all transactions are backed by tangible assets as opposed to intangible ones, such as debt. Now, imagine again that all the now defunct sub-prime mortgages were backed by tangible assets instead of by cheap credit. People would be less tempted to take out a loan which they could not afford if that had to back it up with real collateral. Could this avoid the sort of turmoil we find in the financial markets now?

It’s hard to say. Of course, we can’t pretend for this to be a panacea and it seems unrealistic to eliminate interest; but, surely, it is worth thinking about the ethical (and economic) implications of interest anew. On the other hand, the downside to not having access to credit, however, is that it can make growth more difficult and has the potential exacerbate income inequality. What if one has little to offer the bank for collateral in the first place?

It is worth taking note, though, that Islamic finance is among the fastest growing financial industries, now estimated to be worth over £250 billion. And it’s not just in the Middle East either – the UK, to take one example, is fast becoming a key centre for its business as western banks, such as HSBC, Barclays, UBS, Deutsche Bank and others, begin to offer Sharia-compliant products. The most popular, however, are the purely Islamic banks whereas the western banks are viewed with more scepticism.

With recent changes to the UK tax system last spring to make Islamic financial products more fairly taxed, this multi-billion dollar market is growing between 20-25 per cent annually, perhaps more in other areas. The UK government also looks set to introduce Islamic bonds.

Given the ongoing credit crisis and its subsequent shortage, a financial product which doesn’t require credit should prove attractive to Muslims and non-Muslims alike.