FORTUNE
Monday, June 10, 2002

ISLAMIC FINANCE

Banking On Allah
Devout Muslims don't pay or receive interest. So how can their financial system work?

By Jerry Useem

There's nothing in Osman Abdullah's bearing to suggest an Islamic fundamentalist. He's a businessman, sober in dress and political outlook. Ask him about America, and he'll talk fondly of his time at the University of Wisconsin, where he earned his MBA. But when it comes to his banking habits--and the Koran's ban on giving or receiving interest--Abdullah turns deadly serious. "Allah gave us very clear instructions: Don't make money on money," he says. The words from Chapter 2, Verse 278 of the Koran are, in fact, quite specific: "O you who believe! Have fear of Allah and give up what remains of what is due to you of usury.... If you do not, then take notice of war from Allah and His Messenger." "If I break that," says Abdullah, "I'm dead sure that I'm going to get very bad results in the hereafter. I believe it as I believe in talking to you now."

We are talking, just now, outside Shamil Bank in the tiny Persian Gulf state of Bahrain. It's the bank where Abdullah keeps his money, and, except for the tellers' untrimmed beards and the section for ladies' banking, it looks much like any other: customers standing in line, an ATM machine, a hum of efficiency.

But Shamil is not like any other bank. For starters, Abdullah's savings account isn't really a savings account at all, but something called a mudarabah account: Instead of earning fixed interest, his savings are invested directly in a range of ventures, such as construction projects and real estate. "In Islam, money has to work," Abdullah explains. "If it works, we have to share the profits. If it doesn't, you don't owe me anything else." That means his nest egg could shrink if enough of those ventures fail. But, he says, "I'm willing to take the risks."

So, it turns out, are an increasing number of Muslims. At a time when the words "Islam" and "finance" are more likely to conjure the association "terrorist money laundering," the Muslim world has quietly embarked on a very different sort of jihad: building a financial system where interest--a phenomenon as old as money itself--does not exist.

Spread across the Middle East and beyond are more than 200 Islamic financial institutions: banks, mutual funds, mortgage companies, insurance companies--in short, an entire parallel economy in which Allah, not Alan Greenspan, has the final say. Industry growth has averaged 10% to 15% a year. Sniffing opportunity, conventional banks like Citibank and HSBC have opened Islamic "windows" in the Gulf. And while the industry's market share is still modest--about 10% in Bahrain--its very existence challenges the modern assumption that global capitalism flattens all before it.

Which leaves just one question: How on earth can it work?

This spring, Shamil Bank helped Abdullah buy a car through a transaction known as murabaha, which is more distinct from mudarabah in function than in spelling. In a deal you'll never see from GMAC, Abdullah identified the Toyota Corolla he wanted, then asked the bank to buy it from the dealer for roughly 3,600 dinar (about $9,500). At the same time he agreed to buy the car from Shamil for 4,000 dinar, to be paid in monthly installments over three years. The two sales were executed almost simultaneously, but because Shamil Bank took possession of the car for a brief period of time, everything was kosher. Or rather, hilal.

The result looked a lot like interest, and some argue that murabaha is simply a thinly veiled version of it; the markup Shamil charges is very close to the prevailing interest rate. But bank officials argue that God is in the details. For example, any late fees Shamil collects must be donated to charity, and the bank cannot penalize a borrower who is genuinely broke.

Mortgages, meanwhile, are out of the question for Abdullah. That's why a house he's building in his native Sudan sits unfinished near the Nile River. "I started it four years ago," he says. "Sometimes I stop the construction until I collect enough money."

Given the inconveniences, you might ask: What's the point? Can earning a little interest really be such a big deal? Bahrain's most eminent Islamic scholar provided some answers.

I found Shaykh Nizam Yaquby at the back of his family's store in Bahrain's humming market--a diminutive, robed figure partly obscured by the piles of papers and books on his desk. They include both the hadiths, or sayings of the Prophet, and Inside Secrets to Venture Capital, which more or less capture Yaquby's eclectic background. He is trained in both economics (at McGill University in Canada) and in Islamic sharia law (in Saudi Arabia, India, and Morocco). During its heyday many centuries ago, sharia was the world's most vibrant body of commercial law, its contracts recognized from the Arabian peninsula to the Iberian peninsula. Then it fell into a long decline, which Yaquby and other Islamic scholars are doing their best to reverse.

As a member of Shamil Bank's five-member sharia board, Yaquby issues fatwas, or opinions, on which transactions are Islamically acceptable and which are forbidden. On the day of my visit he was dispensing advice to a steady stream of callers. Was it sinful, a 15-year-old boy wanted to know, to continue living in his father's house while his father was receiving interest?

"There is a hadith: 'The body that is nourished from nonpure sources is bound to go to hellfire,' " Yaquby declared with a somewhat incongruous grin. But his advice to the boy was milder. "My answer to him was that he should advise his father politely and gently. However, the boy was not committing any sin, because his father is responsible in the sight of Allah."

Just how serious a sin is paying or receiving interest? Yaquby noted that Christianity and Judaism got over their hangups about it sometime during the Middle Ages. (The Old Testament offers several stern warnings about interest.) But Islam never really budged. Back in the days of Mohammed, the reasons for deploring interest were pretty self-evident. Loan-sharking was rampant, and failure to repay a loan could mean slavery. By outlawing interest, Islam advocated an economy based on risk-sharing, fair dealing, and equity--in both the financial and social-justice senses of the word.

Islamic scholars believe this system is superior on several counts. It leads to more prudent lending, they say, by encouraging financiers to invest directly in an entrepreneur's ventures. ("A financial system without interest is more interested," says Shaykh Yusuf DeLorenzo, a Virginia-based Islamic scholar.) If adopted fully, say the scholars, interest-free finance would also prevent future Enrons and Argentinas. "One reason for prohibiting interest is to keep everybody spending according to his limit," says Yaquby. "This consumerism society was only created because of the banking system, because it encourages 'buy today, pay tomorrow.' You also have poor economies in debt to rich ones. This is because of borrowing and lending with interest. So this is creating big economic chaos in the world."

Fourteen centuries after these principles were laid down, their application can be a tricky matter. Needless to say, ancient texts are mute on such matters as derivatives and stock options, meaning scholars like Yaquby must extrapolate. Currency hedging, for instance, is prohibited on the basis of gharar, a principle that says you shouldn't profit from another's uncertainty. Futures contracts? Not allowed, since Mohammed said not to buy "fish in the sea" or dates that are still on the tree. Day trading? Too much like gambling. Credit cards? Not cool, though debit cards are.

Bonds? Well, that's where the disagreements start. Malaysian scholars have approved the issuance of specially designed "Islamic bonds." But Middle Eastern scholars, who take a harder line than their Far Eastern counterparts, have roundly criticized them. "Playing semantics with God is very dangerous," warns Yaquby. "Calling fornication 'making love' doesn't make it any different."

Everybody can agree on one matter, though: It's okay to buy and sell stocks, since stocks represent real assets. And now they can be traded safely using the Dow Jones Islamic index.

Launched in 1999 with the help of Yaquby, the index offers a prescreened universe of stocks for the devout stock picker. One screen removes companies that make more than 5% of their revenues from sinful businesses. That expels such notables as Vivendi (alcohol), Citigroup (interest), Marriott (pork served in hotel restaurants), and FORTUNE's parent company, AOL Time Warner (unwholesome music and entertainment). A second screen eliminates companies with too much debt, the cutoff being a debt-to-market-capitalization ratio of 33%. A third screen applies the same standard to a company's cash and interest-bearing securities, while a fourth makes sure that accounts receivable don't exceed 45% of assets. "Islamic investing is low-debt, nonfinancial, social-ethical investing," explains Rushdi Siddiqui, who manages the index at Dow Jones.

Of the 5,200 stocks in the Dow Jones global index, 1,400 make the cut--yet even those may not be entirely pure. If a company makes, say, 2% of its money from selling pork rinds, an investor must give away 2% of his dividends to charity, a process known as "portfolio purification." Then, too, he should urge management to exit the pork-rind business.

So what does a typical Islamic portfolio look like? Actually, a lot like the Nasdaq 100, since technology companies tend to carry acceptable levels of debt. That made for a rough 2001, as favorites like Microsoft and Intel sputtered. But demand for Islamic mutual funds is booming. There are now more than 100 funds worldwide, including three based in the U.S., while a clutch of Internet companies position themselves as the Muslim E*Trade (iHilal.com), the Muslim Morningstar (Failaka.com), and the Muslim Yahoo Finance (IslamiQ ). The latter offers members a feature called "Ask the Scholars."

All of which raises another question: How high a price must investors pay for following the rules? "Some people say you have to apply the COBM--the Cost of Being Muslim," says Yaquby. But he and others insist that no such tradeoff exists. Obey God's rules, in other words, and your portfolio will prosper.

It is an argument that holds great appeal in the Arab world, where moral decay is frequently blamed for the region's millennium-long material decline. Nostalgia for the lost golden era of Muslim power has been a strong impetus for Islamic banking. "The Islamic economy covered half the world," says Jamil Jaroudi, Shamil Bank's head of investment banking. "How do you think Islam reached Indonesia and Malaysia? It was through traders, not jihad." Indeed, Mohammed himself was a trader who early in his life led a caravan from Mecca to Syria.

The golden era gave way to a period of colonial domination in which Western-style banking was imposed on much of the Islamic world--a source of resentment to this day. (Individual Muslims handled this dilemma differently. Some opened interest-bearing accounts under the principle of darura, or overriding necessity. Others opened accounts but refused the interest. Still others opted for their mattresses.) It was mostly that resentment that gave rise, in the 1940s, to the quasi-academic field known as Islamic economics.

As an attempt to build a "third way" independent of capitalism and communism, Islamic economics was never long on scientific rigor; one contemporary academic calls it "bad moral philosophy with a little Keynes thrown in." But it produced a voluminous critique of Western capitalism and its attendant evils, notably speculation, consumerism, volatility, inequality, "unnecessary" products, large corporations, and of course usury. Whereas conventional economics was built on Adam Smith's notion of harnessing human nature ("Every man working for his own selfish interest will be led by an invisible hand to promote the public good"), Islamic economics proposed to reform human nature. "The intended effect," the University of Southern California economist Timur Kuran has written, "is to transform selfish and acquisitive Homo economicus into a paragon of virtue, Homo Islamicus."

For decades this vision remained just that--a vision. It was the oil boom of the 1970s that turned it into a movement. In 1973, flush with petrodollars and keen to reassert their Islamic identity, Muslim nations formed the Islamic Development Bank, a sort of interest-free version of the World Bank. Two years later the first Islamic retail bank began accepting deposits in Dubai.

Not everyone welcomed the phenomenon. While Malaysia promoted Islamic banks as a constructive outlet for religious fervor, Saudi Arabia would not allow them, lest they imply that the kingdom's existing banks were un-Islamic. (The Saudi royal family, not incidentally, subsists largely on income from conventional investments.) The government finally allowed one to open in 1987, though the word "Islam" was nowhere in its name. At the radical end of the spectrum, Iran, Pakistan, and Sudan officially Islamicized their entire banking systems--in theory anyway. In practice, their fundamentalist clerics had little interest in economics--the Ayatollah Khomeini famously scoffed that the Islamic revolution was not about "the price of watermelons"--and settled for changes that were mostly cosmetic.

Elsewhere, scandal threatened to capsize the whole enterprise. The 1989 collapse of several nominally Islamic investment houses in Egypt led to disclosures about some very un-Islamic practices, such as fraud. And last year's failure of a Turkish Islamic bank, Ihlas Finans, panicked depositors at Turkey's other Muslim banks.

But in banking centers like Kuwait, Dubai, and especially Bahrain, which is known for its strict regulatory oversight, Islamic banking is serious business. A respected group known by the acronym AAOIFI (Accounting and Auditing Organization for Islamic Financial Institutions) has codified sharia rulings into a set of industry standards. The early zealots have given way to more pragmatic professionals. Even the sharia scholars--once recruited from the local mosque and barely fluent in English, much less financial statements--now come toting advanced degrees in economics. "In the last five years," says Shamil Bank's Jaroudi, "the industry has accomplished more than it did in its first 20."

Now it is making inroads in the U.S., home to seven million Muslim-Americans. Here the most pressing issue is home ownership. Since buying a house usually requires a mortgage, many Muslims end up renting their whole lives, thus missing out on a crucial component of the American dream. Azmat Siddiqi was one of them. A manager at Applied Materials who immigrated from Pakistan 22 years ago, he hoped to circumvent the problem by making an all-cash purchase. After years of saving, he, his wife, and their two daughters finally had enough for their dream property: a $1.3 million plot of land facing the mountains in Saratoga, Calif. But then Siddiqi's stock holdings plummeted, leaving him $275,000 short. "I thought, 'By golly, should we let go of it?' " he says. "I looked at the Koran for guidance."

He also looked on the Web, where he discovered a Pasadena-based company called Lariba, which offers a lease-to-own arrangement for Muslim homebuyers. Lariba bought the property in partnership with Siddiqi, who agreed to pay rent to Lariba while buying out its $275,000 ownership share over ten years. Unlike interest, the rental price could fluctuate as market conditions changed. "There was a very high premium," says Siddiqi, 45. "But to me this was like a godsend opportunity to achieve my real estate objective and not incur the negatives of interest."

Lariba is still tiny in relative terms; it closes 15 to 30 mortgages a month. But it recently struck a deal with Freddie Mac that could vastly increase its volume. "We are like ants among the giants," says Lariba's founder, Dr. Yahia Abdul-Rahman. "Insha'allah, we will catch up." Meanwhile, HSBC has begun offering Islamic mortgages in the New York City area.

Despite growing acceptance of Islamic banking, supporters concede that it has a long way to go. The basic problem, they say, is that Homo Islamicus keeps acting a lot like Homo economicus. Take the idea of profit-and-loss sharing. For the concept to work, a bank must know how much profit, or loss, there is to share. Yet in countries with widespread use of double bookkeeping--one for the tax collector, one for the safe--business owners can easily understate profits or overstate losses. "If someone is using [an Islamic bank], it doesn't mean that he is guaranteed to be moral," says Saiful Azhar Rosly, an economics professor at the International Islamic University in Malaysia. "Good Muslims are still tempted by the devil."

Another problem is that profit-and-loss sharing tends to attract entrepreneurs with dimmer prospects, who are looking to share losses in the event of failure. Entrepreneurs with the best prospects are more likely to seek out fixed-interest financing to maximize the returns on their presumed success. The "adverse selection" problem saddles Islamic banks with bad risks.

Perhaps not surprisingly, then, profit-and-loss sharing deals constitute only 15% of Shamil Bank's transactions, while the murabaha double-sale, considered the most gimmicky of techniques, accounts for more than 30%. "We are very careful because [profit-and-loss sharing deals] are very risky," acknowledges Shamil's CEO, Dr. Said Al-Martan. "You have to be involved in the company, which is not easy in this part of the world. It's much easier to do leasing or murabaha."

Such admissions have left the industry open to charges that it has opted for pragmatism over purity--something Islamic hard-liners have pounced on. "And so the core Islamic concepts sit neutered, no longer a different paradigm but instead just another member of the product range," writes one firebrand on the Website islamic-finance.com. "What a humiliation this is for a great body of law." Another writer is even more strident: "The 'Islamic Bank' is a Trojan horse which has been infiltrated into Dar al-Islam.... [It] is a totally crypto-usurious institution and like all other usurious institutions must be rejected and fought."

When I read some of these passages to Yaquby, he smiled patiently. "These are very sincere people, but they are not realistic people," he said. "Of course we would like Islamic banking to have more activities with benefit to society, and also to have more courage in sharing risk. But if you're saying that until we reach this ideal state, we should do nothing, this is where we object. Because until then, me and you have to do banking. We have to purchase our homes. We have to invest our wealth."

These days, Islamic banking faces another challenge: the lingering suspicion that it is connected to terrorism. So far, there is little evidence that its activities are any more suspect than those of conventional Arab banks. (The U.S. government's list of terrorist organizations includes one small Islamic bank, Al-Aqsa Al-Islami in the West Bank.) Islamic finance has always had more to do with conservative, devout Islam than radical, political Islam. Nonetheless, Sept. 11 has put the industry on the defensive, with some depositors withdrawing money for fear it would get caught in an anti-terrorism dragnet. "A lot of investors were frightened, to be honest," says Atif Abdulmalik, CEO of First Islamic Investment Bank in Bahrain." 'Collateral damage,' I call it."

Even if those fears prove unfounded, there's the question of how Islamic finance fits into the broader issues raised by Sept. 11. Could it reduce the Muslim world's isolation by serving as an intermediary between pure belief and pure capitalism? Or will its litany of rules merely build the walls higher? Should it be seen as an innovative force? Or a reactionary one?

Among the optimists is Frank Vogel, a Harvard Law School professor who helps organize the university's annual conference on Islamic finance and has co-written a book on the topic. "It's very much in our interest that it succeed," he told me, "yet I'm afraid that we're going to be against it, that we're going to make all these snotty remarks. Time is running out for healthy, happy experiments like this. The radicalization, the desire to make yourself as ugly to the West as you can--that rage isn't only at us, it's at the secular forces in their own societies. We need Islamicization, because they're not going to stop being Muslims overnight."

Oddly, Vogel's co-author, Harvard Business School finance professor Samuel Hayes III, gave me a different slant. In his view, literalist interpretations of the Koran threaten to choke off Muslim participation in the global economy. "Prophet Mohammed's teachings take very practical account of commerce in the seventh century," says Hayes. "It's not up to me to say, but if he were living today, I think he would find some accommodation. [Otherwise], there's no way a business can operate competitively."

In the end, even Islamic scholars concede that Hayes might have a point. "Once you face reality," Yaquby said shortly before I left his store, "it's not possible to isolate yourself from the whole economic system of the world."

Thanks to brother SH for the article.
Please visit his website at:
http://sahul.netfirms.com

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