Islamic Banking
“Islamic banking” was tested on a global basis in unprecedented ways during this recession. How did it perform relative to other financial institutions, and according to whose criteria?
By its definition, strict prohibition on “usury” and interest driven lending, Islamic banking did not employ traditional leverage and thus fared substantively better in a recession marked by a sharp contraction of credit and liquidity. (Islamic banking lacks an absolute generic model but can be characterized as restricting investments in certain industries, such as alcohol, and interest driven financial instruments).
On the other hand, institutions presumably following “Sharia” or Islamic banking guidelines did not necessarily escape the real asset bubbles, particularly real estate. Seeking out investment opportunities narrowed by criteria as to both industry and financial instrument type could have driven some Islamic banking investors into options that were even more subject to speculation, (further driven up by their presumed theological or moral desirability). Sharia compliant investors may have had a tendency to crowd into a few options.
Forms of “Socially Responsible” Investments
Islamic banking for the more observant Muslim cannot be judged solely by financial performance. It has been driven presumably by factors of theology, morality and conscience in the perception of the investor. In this manner, it should not be judged any differently from other forms of “socially responsible” driven financial options, whether defined by ethical, political or other religious criteria, such as those consistent with Catholic orthodoxy.
Islamic banking though has come at a unique time. Adherents have been blessed with an unprecedented inflow of income, and not simply from energy resources. There is a substantial concentration of new wealth and liquidity that has allowed Islamic banking institutions to grow dramatically and exert their dynamic impact in most economies and financial markets, and beyond the “Islamic world.”. Some countries, (including non-Muslim majority states as Singapore, Germany and the United Kingdom), that have been more forward looking and evolved regulatory and tax considerations to reflect Islamic banking, have managed to benefit their economies and attract new investment capital.
Judging Success & Cannibalistic Orgy
The performance of Islamic banking relative to its more traditional financial cousins is not a simple comparison. Notions of default and debt restructuring are not readily assigned to Islamic banking. The challenges faced by Islamic banking were not the same as those faced by the more traditional financial institutions, either in degree or form.
In that one critical consideration, over leverage, that was the hallmark of this recession, Islamic banking had an inherent advanyage. Less leverage turned out to be decisive, the difference between surviving the global economic crisis and collapsing from the overwhelming burden of unmanageable debt. Before the crisis, debt was perceived as a means to leverage into ever-greater positions and gains. However, when the traditional financial system began to implode, leverage transformed from a crown of wealth into a crippling collar ever tightening around the throat of many more traditional financial institutions. Predatory action by market opportunists turned small wounds into unwieldy tears profusely bleeding capital. While some banks and even hedge funds sought time as the critical resource to recapitalize, other market participants exploited this panic to prey upon real and projected weaknesses. While many suffered from the crisis, others sought to gorge themselves through predation that at times resembled cannibalistic orgy.
Perhaps it was mere good fortune that Islamic banking was not exposed to leverage at the critical point when such transformed from desirable to fatal disadvantage. However, Islamic banking does have other inherent advantages beyond the very subjective theological considerations that are valued by the more observant. There is clarity in the link between the financial instrument and underlying asset. The more direct connection between “borrower” and “creditor” afforded by many Islamic finance institutions can offer greater accommodation, and especially when it is most needed in time of crisis and dislocation of the anticipated rules and criteria. And, while Islamic banking perhaps has not been totally free of its own scams, the nature and relative transparency did not allow for Bernie Maddof type schemes to perpetuate into billion(s) dollar frauds.
Bailouts
Objectively, Islamic financial institutions have not consumed the billions, trillions that traditional financial counterparts did on a global scale. To the extent that support was provided by governments to Islamic banking it also was more subtle and maybe thus more difficult to discern.
Islamic banking though also has its substantive disadvantages, and some turn out to be the flip side of the perceived advantages. Some were likewise highlighted during this economic crisis. As some investment options were limited by theological considerations, Islamic banking tended to be over exposed to certain asset types, particularly real asset financing, from commodities to real estate. Speculation was an across the board failing and Islamic banking fared less dramatically only because it had not been allowed to employ excessive leverage which had magnified the problem in more traditional financial institutions.
Seeking Standardization
Islamic banking, in a generic context, also continues to suffer from both self inflicted wounds as well as a lack of acceptance or adequate accommodation within certain major political borders. Islamic banking still lacks efficiencies brought about by standardization, and anonymity. While Islamic banking is a truly global presence, it lacks global criteria and standardized reach.
There is a lack of standardization both as to the actual “Sharia” or theological requirements to be applied to investment criteria as also with respect to the financial instruments. (Regarding review of a potential investment in a pool of premier food warehouse in which I was recently involved, the discussion focused on how much of the food handled by the warehouse was pork in the North American and Western European markets served by such).
Islamic banking frequently mimics traditional debt instruments in many western economies, sometimes as the means to fall within relevant regulatory and tax considerations. While such may have brought Sharia compliance as reviewed by local Islamic theologians, nonetheless there frequently was a lack of standardization in the underlying financial instrument. This has made it difficult for the syndication of such financial instruments or the evolution of a secondary market that distributes and diversifies risk or segments such according to risk appetite.
Of course, part of the issue is whether it is a positive evolutionary path, especially in the context of Islamic banking, to impersonalize investments and “lending”. Syndications, securitizations and secondary markets have been perceived as ever more critical element of “risk management” within traditional financial institutions; however even the notion of risk may be evaluated in a substantively different way in Islamic banking. Certainly the relative success, growth and righteousness of “micro credit” lending largely independent of traditional big banks, has proven a third way.
Islamic Banking as a Mutually Beneficial Alternative
The value of Islamic banking is perhaps in the eyes of the beholder. To more observant Muslims, it may be a theological, even spiritual necessity. On the other hand, it has been viewed by some others with suspicion or even disdain.
From a more objective, even macro-economic perspective, Islamic banking can only be understood as an alternative among many that coexist in the field of financial institutions and inter-relationships. In the current environment where too much leverage has come to be understood as continuing to pose a potential danger to national and global financial health, Islamic banking brings needed equity in the ongoing de-leveraging process where nonetheless liquidity is still critical. It especially now carries benefits for the broader society. Nonetheless, it is fair to ask: has Islamic banking developed to meet its already evident global financial influence? Efficiency is not only determined by containing cost and greed, but it may also be about branding and recognition, predictability and sustainability, volume and broader market appeal.
Over the next few years Islamic banking can be expected to address the following considerations:
- Standardization of theological or Sharia considerations as to make review of potential investments more predictable, timely and efficient. (“Micro credits” may not be theoretically compliant with strict Sharia application; however the good in raising millions out of poverty and starvation toward self sufficiency is an example of perhaps where substance is as or more important than form. Muhammad Yunus, a Muslim of SE Asian background is largely credited for pioneering micro credits. The innovation has now been adopted by some more traditional financial players, from the World Bank to George Soros, as well as having garnered Yunus recognition from the Nobel and The US Medal of Freedom mostly recently awarded by President Obama).
- Enhancing opportunities to diversify and better manage risk through further evolution of syndication, secondary market and securitization options balanced with the more personal approach of Islamic banking.
- As in more traditional Western investment instruments, the possibility of structuring differentiated classes, segmentation, of “creditors” in order to match risk/return appetite preferences again in the context of also meeting theological considerations and the generally more personalized nature of Islamic banking.
- Development of independent evaluations, such as rating agencies, as a means of more objective analysis and grading of financial quality/criteria as well as furthering standardization or securitization.
- National governments will need to further evolve their regulatory and tax systems to be Islamic banking receptive and take advantage of the enormous capital available. (The US, perhaps betrayed by broad negative generalizations and stereotyping, has been one of the laggards, at least until recently as compared to many other Western economies).
- Islamic banking institutions will have to broaden their investment horizons, geographically and by industry, in order to reduce potential over-exposure, concentration and speculation.
In evaluating the future role as well as recent past of Islamic banking it is too easy from both sides of the spectrum to focus on the theological and allow a pragmatic financial debate to become ideologically heated. I see it much more in the context of the freedoms and options offered by open societies and free markets. The US is not only a multicultural, pluralistic society but one which gave rise to the expression: “give the consumer what he wants,” and presumably this applies to theological considerations in banking as much as to the fashion cut of clothing.
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