Islamic finance: myth vs reality

Clearing 10 common misconceptions about Islamic finance. Misconception 1: Islamic finance is a front for financing terrorism


Islamic finance is a genuine, legitimate business, offering Sharia-compliant financial products as an alternative to existing financial products.

Islamic financial institutions are regulated and supervised in several jurisdictions and bound by strict laws, including anti-terrorism and anti-money laundering laws.

The Sharia considers illegal use of violence, especially against innocent victims, a heinous crime and categorically condemns terrorism. As a matter of principle, an Islamic financial institution is strictly prohibited by the Sharia from knowingly assisting, let alone actively participating, in terror-related activities.

Misconception 2: Islamic finance is only for Muslims


Conventional banking groups like Citigroup, HSBC and Standard Chartered are among the largest providers of Islamic financial services; prominent entities such as GE, Nestle, Shell MDS, the International Finance Corporation and the Asian Development Bank have raised money through sukuk.

There is no prohibition against non-Muslims using Islamic financial products or owning institutions that offer Islamic financial services.

The moral and ethical values espoused by Islamic finance may be appreciated by anyone, regardless of faith: the injunction against usury is common to Islam, Christianity, Judaism, Buddhism and Hinduism; non-Muslim investors may also subscribe to the ethical parameters that forbid Islamic investments in sectors such as alcohol, gambling and pornography.

Misconception 3: Islamic finance is a replica of conventional finance


The differences between Islamic and conventional financial products are not always obvious. But the fact remains that the former are consciously designed to avoid prohibited elements such as riba, maysir and gharar, unlike their conventional counterparts.

While there are similarities between the two, especially in terms of the economic objectives of their users, in terms of risks, Islamic finance products form a new asset class and hence add depth to the diversification of risk for users.

Sharia compliance has meant that Islamic banks can use fewer risk hedging techniques and instruments such as derivatives and swaps than conventional banks. Interestingly, this prohibition against the use of derivative products and short selling activities has largely shielded Islamic finance from exposure to 'toxic assets'.

Though not unscathed, the resilience of Islamic finance in surviving the recent financial turmoil has attracted new interest in its fundamental principles and business models.

Misconception 4: Islamic finance is primitive and non-standardized


Islamic finance offers a range of products catering to industry users in banking, insurance, capital market and wealth management; it is also used in a broad range of sub-sectors, from micro-financing to public infrastructure financing.

Many Islamic financial institutions offer e-banking services and mobile banking, use electronic trading platforms, and take advantage of sophisticated software and hi-tech solutions to increase efficiency in their operations.

The industry is increasingly adhering to a high standard of international best practices in the areas of product standardization, accounting and financial reporting through governing bodies such as the Auditing and

Accounting Organization for Islamic Financial Institutions (AAOIFI), the Islamic Financial Services Board (IFSB), and International Islamic Financial Markets (IIFM), as well as through existing international standards that do not contravene the Sharia.

Misconception 5: Islamic finance is more (or less) risky than conventional finance


The maxims 'al kharaj bil dhaman' and 'al ghunm bil ghurm', which ordain that rewards or gains can only be justified by the risks taken, underscore the recognition of the element of risk in Islamic finance.

Just like in conventional finance, different financial contracts, investment strategies and risk management tools are available to accommodate different risk appetites. However, the prohibition against maysir (betting/gambling) prevents market players from exposing themselves to excessive risks.

A 2008 IMF study provides empirical evidence that Islamic finance is not necessarily more or less risky than conventional finance: for example, profit/loss-sharing financing shifts direct credit risk from banks to investment depositors; however, it also makes Islamic banks vulnerable to risks normally borne by equity investors rather than debt holders.

Misconception 6: The cost of funds is lower (or higher) in Islamic finance


Under Basel II, the three major components of risk for a conventional bank are credit, market and operational risk. Islamic financial institutions, due to their business model, have to also take into consideration other risks as well, such as Sharia-compliance risk, displaced commercial risk and fiduciary risk arising from profit-sharing investment accounts. Islamic financial institutions need to allocate capital to cover for these risks, and may not necessarily find it cheaper to operate than their conventional counterparts.

Even though no interest can be imposed under an Islamic finance contract, financiers still have a right to earn appropriate profits from their funds. And while the Sharia generally prohibits the imposition of penalty for delayed payments, Islamic finance does recognize the time value of money.

For products in which financiers have to bear more risk, they would expect to obtain a higher rate of return, while in products where the risk exposure is lower the pricing may be in favor of the financed party. Thus, Islamic finance can be a cheaper source of funds through design and negotiation, but it is not a given.

Misconception 7: Islamic finance offers no guarantee


While the Sharia prohibits financed parties from providing to financiers a guarantee of capital or returns, it does permit for a guarantee to be provided by a third party to the transaction, if given at no consideration.

This is in line with the principles of kafala (guarantee or surety) and taawun (mutual assistance or solidarity among Muslims), from which the concept of takaful (Islamic insurance) is derived. Hence, it is not uncommon in any financial transaction that risks are mitigated through the instrument of takaful.

Islamic finance applies different techniques to preserve the rights of financiers as compared to conventional finance. A majority of Islamic finance transactions are arranged as sale or leasing contracts, minimizing the moral hazards and high monitoring costs. A charge or caveat can be registered on the subject matter of the sale or lease as collateral to safeguard payments.

Misconception 8: Islamic finance is 'welfare' finance


There is an inherent mechanism encouraging Islamic financial institutions and their stakeholders to undertake corporate social responsibility, with the institutions of zakat (mandatory alms), sadaqa (voluntary donations) and infaq (gifts), as well as hilm (forbearance).

While the tenets of Islam do recommend forbearance for debtors facing genuine difficulties in meeting their obligations, there is also an explicit warning against deliberately defaulting on payment of debts without cause.

Islamic financial institutions strive to strike a balance between earning profits and serving the broader needs of the community. Still, while they accommodate customers having difficulties repaying debts and exercise restraint in undertaking legal recourse, these institutions are ultimately profit-oriented entities answerable to shareholders, investment account holders and other stakeholders.

Misconception 9: Islamic finance is governed only by the Sharia


When it comes to resolving disputes arising from Islamic finance contracts, Sharia rules and principles do not necessarily apply. Often, the issues in dispute are not Sharia in nature; they concern civil and commercial rights and obligations as contracted by the parties. For example, to enforce a charge over a collateralized asset or property, the remedy available and sought would be the remedy provided under land laws.

The interface between the Sharia and civil or common law systems is bound to occur, especially in international deals. Still, English law has widely been chosen as the governing law for many international

Islamic finance deals involving sukuk, with cases being referred to English and US courts.

In countries such as Malaysia, the constitution specifically enlists banking and mercantile matters as within the jurisdiction of the civil courts and not Sharia courts, resulting in numerous Islamic finance disputes being decided by judges trained under common law and not under Islamic jurisprudence.

Misconception 10: Islamic finance is driven purely by the oil boom


While petro-dollars have been a catalyst for growth, the Islamic financial services industry has enjoyed steady 15-20% annual growth since its inception in the 1970s, even before global petrol prices shot up.

Factors playing a growing role include: increasing awareness among the Muslim population about the availability and feasibility of Islamic financial products; development of innovative Sharia-compliant instruments adding depth and choices to the market; licensing of new market players catering to different segments; and tax and fiscal incentives by governments.

In recent years, Islamic financial institutions have been expanding operations beyond their traditional borders, even as many Middle Eastern countries have embarked on massive infrastructure projects financed through Sharia-compliant means.

© Zawya BusinessPulse 2013


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