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Islamic finance over the last three decades or so has grown into a huge industry. It is huge both in the sense that vast sums of money are handled by Islamic finance, and also in the sense that a great many scholars have been attracted to it, and they have helped to invent or justify financial instruments which claim to make it lawful for Muslims to do things with their money very similar to the things that non-Muslims do with theirs. Yet, if using the word 'Islamic' before 'finance' is to mean anything at all, it should mean the kind of finance that belongs in Islam, the kind that Muslims acting specifically as Muslims engage in when they are producing and exchanging goods and services, and generally building up their individual and collective means of livelihood.

Most ordinary Muslims are, I think rightly, suspicious and cautious about accepting the permissibility of many of these instruments. It does not help matters that banks and investment companies run by and for non-Muslims are happy to use these same Islamic financial instruments because it helps them to attract and keep Muslim customers.

That sounds very similar to, for example, a supermarket stocking halal meat in the hope of attracting the business of the Muslims in its neighborhood. It is indeed similar, but it is not the same. There are known and clear procedures that must be followed before meat is called halal, and perhaps it does not matter that, at the final point of sale, the retailer is a non-Muslim – provided those procedures have been correctly and fully observed. It is not at all so clear-cut with money. Money is something abstract and symbolic as well as real and concrete. It is not just a store and physical sign of value; it is also a means of assigning and exchanging the values of different goods and services. Accordingly, it permeates all human relationships that are connected in any way to the exchange of goods and services.

That is why it matters very much to Muslims to know that the money that is circulating among and around them is, from an Islamic point of view, sound and safe, and that the transactions being done with that money are also sound and safe. The scholars engaged in developing, and justifying, Islamic financial instruments are engaged in the effort to provide Muslims with the assurance that those instruments are sound and safe from an Islamic point of view.

In order to judge whether and how far those scholars have succeeded in achieving this goal, it is necessary to step back and ask how we can know if a practice is sound from an Islamic point of view. Before we can do that we need to take a further step back and ask whether and how far such a task is possible at all. In other words, before I get into a discussion of particular instruments and contracts now being offered as Islamic finance, I want to establish as clear a framework as possible for this discussion. This is a necessary prelude to reaching a balanced judgment about these instruments and contracts based on a sufficient appreciation of the external necessities and the internal assumptions and arguments (some persuasive, some not) which have led Muslim scholars to seek out some sort of Islamic rationale for various modern financing techniques.

The world as we find it has in it three distinct orders that overlap and interpenetrate. The largest order encompasses all creatures, living and non-living, human and non-human, Muslims and non-Muslims, all together. We can call it “the natural order”. It is perceptible and intelligible to human beings; to some extent they can work out how it operates and, in some measure, influence and control what happens around them. This order includes the boundaries of time and space, and what modernists in the West call the laws of nature, to which everyone and everything is subject, involuntarily. Within that natural order, there is “the religious order” of divine commands communicated to human beings through God's prophets and messengers. This order is addressed specifically to human will, and demands a conscious, consenting, voluntary obedience. Finally, there is “the Islamic order” of divine instructions that bind specifically Muslims, commanding or commending them, through the Book and the teachings of God's Messenger to live in certain ways and to avoid certain other ways.

Because these three orders exist together in the one same world, it is sometimes the case that the approval of a certain way of acting as Islamic, as conforming to the Book and Sunnah, does not at all contradict its being approved by non-Muslims as “practical' or “useful” or “sensible” or “healthy” for the individual or for society. Non-Muslims just like Muslims get hungry and need food; get ill and need medical attention; get attacked and need to fight; get curious and need to explore and travel. Then, if Muslims find notably effective ways of serving these needs, we cannot be surprised if non-Muslims adopt those ways. That is obvious. It is also obvious that the converse applies: to serve their basic wants and needs, Muslims can in principle adopt ways that are or were the ways of non-Muslims. That is surely true. But it is also true to say that, in some instances, no matter how “useful' or “efficient” certain means are for the achievement of certain ends, Muslims as Muslims will reject them as unIslamic. How do they decide when they may and when they may not adopt the ways of non-Muslims? This is not an easy question. For the time being, let us note that if we are going to refuse certain financial instruments or transactions as unIslamic, we cannot do so simply on the basis that they are of “Western” or non-Islamic origin. We must have a better reason than that.

When we try to implement the rules and norms that constitute the Islamic order, we are not exempt from the conditions that obtain in the natural order. Accordingly, those Islamic rules and norms must be implemented with a measure of flexibility. For example, in a situation of necessity, where Muslims have no freedom of action or choice, what is normally prohibited is considered lawful for the duration of the necessity. This indulgence is intended to be temporary, exceptional. It is conditional on Muslims not desiring that which is normally prohibited. The only reliable proof that Muslims are not desiring what is normally prohibited to them is that they are striving to remove themselves from the situation in which they have no freedom of action to a situation where they do have such freedom. So, even if we are forced to adopt novel kinds of financial instruments or transactions on the basis that Muslims are so powerless in the world that they have no choice but to submit to the global financial order, there is, nevertheless, no compulsion whatever to legitimize such instruments or transactions by calling them “Islamic finance”.

All humans in the normal state of things have a measure of freedom of action. What distinguishes Muslims as Muslims is that, in the normal state of things, they strive to use that freedom of action in obedience to the will of God insofar as that is known to them through the teachings of Islam. To the extent that they consciously strive to do that, their lives fulfill the purpose for which the Book tells us they were created, namely to worship God. For believing, practicing Muslims, the natural order of this world, its being perceptible, intelligible, useful, beautiful, etc., is the wide space, provided by the Creator, within which human freedom of will and action are experienced as a reality. If the natural order were not as reliable as it is, freedom of will would not be experienced as real. But the natural order is there, real and reliable. That is why human life in this world can function as an enabling test, a test through which Muslims learn to perfect their obedience to God's will and so earn the promised recompense hereafter. Thus, we should expect from Islamic finance and the financial instruments it invents or justifies that they help Muslims to (at least) avoid doing what God has prohibited, and (ideally) help them to do more easily and conveniently what God has permitted. This is not a matter of clever word games, clever labeling. Surely Muslims will not accept as permissible the kinds of transaction they had long believed to be prohibited, even if Islamic economists find clever ways to label them as permissible.

But, you will ask, how are things known to be permitted or prohibited; how do they get entered into one or the other category? The answer is that we find out by referring to Islamic teachings on the matter in question. But then we must ask: how do Islamic teachings decide the matter in question?

In answering that, people often confuse two things – they confuse the authoritative sources of Islamic teachings, the Qur'an and Sunnah, with the rulings derived from those sources by Muslim scholars. The confusion leads to very serious difficulties for Muslims if, in principle or in practice, they accord to the derived rulings the authority of the primary sources. For reasons that will become clear later, I will use for the derived rulings the term “doctrines”. For the teachings in the primary sources, I will use the term “guidance”. Now, we can and do refer to the doctrines that constitute the Islamic legal and cultural tradition that we have inherited. We study and respect those doctrines; we learn from them; if we don't know any better (and 99.9 per cent of the time we really don't know any better), we follow them to the best of our ability in our circumstances. But the promised recompense hereafter for obedience to God's will does not depend on our following the derived doctrines; it depends for sure on our following the guidance in the primary sources. Of course, for most of us most of the time, because of our deficiencies in 'ilm and taqwa, in our knowledge and wariness of God, following the doctrines is the best way we know of following the guidance.

The title of a recent blog post that drew over 100 comments on MuslimMatters read “Halal Mortgages: Alleged Misuse of Taqi Usmani's Fatwa and 3 Important Questions.”  What began as perhaps a sincere attempt by the author to alert readers about the abuse of a respected scholar's fatwa and invite Islamic financial institutions to provide as he put it “a little bit of transparency”, resulted in a heated online debate that achieved very little in terms of “removing doubts” about Islamic home finance companies in the US, as originally intended.

Because Guidance Financial Group and its subsidiary, Guidance Residential were mentioned in both the blog and the comments that followed, we felt that a response was appropriate to counter some of the misinformation that has been spread not only about our company, but also the chairman of our Sharia Supervisory Board and the six fatawa he and the other prominent members of our board issued specifically for our Declining Balance Co-Ownership Program. Guidance has helped thousands of Muslim-American families become homeowners through this authenticated program and since our inception in 2002, we have always believed in the value of transparency having issued a comprehensive WhitePaper that provides insight on our unique and pioneering structure.

It is important to start off by clarifying one major matter that could go unnoticed by the reader. It is that the blog begins by quoting Mufti Muhammad Taqi Usmani as saying “I have never approved any ijarah contract or scheme for any financial institution in America, Australia or Canada.” We would like to emphasize that this statement is in no way, shape or form directed at Guidance or its Program. It is unfortunate that the author mistakenly refers to the ijarah model as a “co-ownership” while in reality Guidance does NOT and has never used the ijarah (lease) structure or contract. Guidance's Program is based on a musharakah mutanaqisa (diminishing partnership) structure, which was developed with the help of and finally approved by our Sharia Supervisory Board led by none other than Mufti Taqi Usmani as its Chairman.

The underlying question that needs to be asked is how can Muslims determine if a financial contract or institution is in compliance with Islamic financial transaction principles? For starters, we would need to know who are the scholars behind the product or institution.  To develop our Program, we spent millions of dollars in research and development over the course of 3 years and involved 18 different law firms while working with 7 of today's most authoritative and highly respected scholars in Islamic finance. The scholars are from 6 different nations and are trained in the different schools of thought. Throughout the development process and beyond, these ulema researched and debated all aspects of Guidance's Program, including the life cycle of the transaction and how it would involve an actual home-buyer.  Eventually, ijma (consensus) was achieved among these renowned scholars and a formal certification through the issuance of fatawa was complete.

To further validate our approach and our Program, one can evaluate the scholars themselves to assure that they are qualified in matters relating to Islamic financial transaction principles. In doing so, you will find that a majority of Guidance's Sharia board members belong to the prominent Sharia board of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI, pronounced “a-yo-fee”), formed in 1990 as an independent, non-profit, international standard-setting body, AAOIFI is the industry standard for Islamic finance practitioners. AAOIFI's regularly updated texts have become the definitive reference work for those seeking a comprehensive rule book about internationally recognized standards in Islamic finance. Its 85 standards cover everything from accounting and auditing to governance and product-specific Sharia standards. The 20 international scholars who sit on AAOIFI's Sharia board are distinguished Islamic scholars who are legally qualified to issue a fatwa and adjudicate on matters of Islamic finance. Guidance is privileged to count among the members of our Sharia board a quarter of AAOIFI's most eminent and authoritative scholars in Islamic finance. In fact, the Chairman of AAOIFI's Sharia board is none other than Mufti Taqi Usmani.

Guidance and its distinguished Sharia board have been sought after for technical expertise in Islamic finance by international organizations in Saudi Arabia, Malaysia, Egypt and Indonesia. In 2007, Guidance helped establish what has become today's leading home finance institution in SaudiArabia – DarAlTamleek. In 2009, Guidance was nominated by the Dubai-based international trade publication Islamic Business and Finance Magazine for the “Best Islamic Home Finance Provider” award. All these efforts did not go unnoticed by the mainstream media and in fact, major outlets like The Wall Street Journal, The New York Times, The Washington Post and even Al Jazeera to name just a few have all recognized Guidance's pioneering endeavors. We hope that more Muslim media outlets delve in to this subject in greater detail for the benefit of our community as a whole.

We would like to extend an open invitation to all of the Muslim Matters staff and its bloggers to talk with us directly and even visit with us at our corporate headquarters in Reston, Virginia. Furthermore, please feel free to communicate directly with me, Hussam Qutub, and ask any and all questions by emailing me at communications@guidanceresidential.com.

In addition to relaying all of the above, Guidance's intention in writing this post was also to answer the questions posed by the author of the article. To that end, we have provided our answers below.

MMQ1:         How often are updated contracts reviewed and approved by a Shari'ah board (“SSB”), and which scholars have signed off on the actual contract being used by an Islamic finance company?

 A1:          Our full Sharia board has signed off on our program as you can see from the link above.  Our Declining Balance Co-Ownership Program documents have not changed from the time reviewed by the scholars. Subsequent to those fatawa, in 2005 and 2006, two additional fatawa were issued to certify adjustments that needed to be made in order for us to serve Texas Muslims while adhering to their state's unique challenges and the second to introduce adjustable programs that were in high demand at the time.

While there have been lots of changes in the mortgage business since the credit crisis in terms of licensing and disclosures, these changes have not impacted our contract or the documents reviewed by our Sharia board. As an FYI, our agreement with our investor, Freddie Mac, does not involve a lending and borrowing relationship of any kind.  And although they have made significant underwriting and operational changes, their documents also have not changed since we started the Program. Part of the reason our contract has stayed intact is that we have a unique and exclusive contract with Freddie Mac. No banks or financial institution can use our agreement without our permission. Additionally, banks in general cannot use our contract by law because banks cannot co-own, they can only lend.

MMQ2:         Are all practices done by the Islamic finance institution during the course of the contract and “declining co-ownership” Shari'ah approved?

 A2:          Yes and we continue to be compliant in all aspects of our business and we are not aware of any aspect that is not compliant.  The entire course of the contract from purchase, transfer and full ownership by client has been studied, observed and deemed compliant with Sharia principles. It is important to note that many disclosures are federally mandated requiring us to use them even though their terminology mischaracterizes the nature of our Program.  For this challenge, we have a fatwa on disclosures that can also be found in the link above.

To further address the authors comments for this question:

“The company itself tried to say that they simply transferred the administrative duties of collecting payment. However, the paperwork from the other bank indicated clearly the transferring of the debt (i.e. selling the debt) from the Islamic company to the bank.”

 Recently, to enhance our customers' overall experience we transferred the servicing of our contracts to a new vendor, namely US Bank's servicing division. To better understand this transfer one would need to understand “servicing” and its place in the mortgage industry. In simple terms, it means collecting and administering monthly payments, mailing monthly statements, fielding questions and handling late payments. For a company of the size of Guidance, this administrative task is usually contracted out to vendors that will then act on behalf of a home financing company and become an extension of their operation. In our situation, although the vendor handles all our correspondence with existing customers, everything is done in our company's name and all payments made by our customers are made to Guidance.

The process of transferring from one servicer to another is a complicated and often challenging administrative process.  There are federally mandated letters that must be sent out to all customers by the old and new servicer on behalf of the home financing company. During our transfer period, some of this mandated correspondence was sent out on our behalf with language that did not properly characterize our Program. Unfortunately, this caused some concern among our customers and we have since worked diligently to address and clarify the situation.  At the end, we admit that this could have been handled better but it must be said that this in no way changes the contract or compromises our program. If it is unclear or requires any further clarification, please contact us.

MMQ3:         How are inconsistencies between what Mufti Taqi Usmani advocates in his writings and the actual schemes used by these banks to be addressed?

 A3:          First, we recommend that all Islamic financial institutions establish an independent Sharia board consisting of specialized, distinguished and credible scholars that regulate their specific products and services in the context of laws in the land they wish to operate as Guidance has done. Second, consumers need to do their due diligence in understanding not only who the scholars are but also how the program is designed to work.

If one were to investigate further in Mufti Usmani's writing and our White Paper, which was approved by our board, Guidance's Declining Balance Co-ownership Program is designed to create a co-ownership for the purpose of providing the home-buyer with financing to acquire a home. This co-ownership is based on Shirkat ul Milk. It is not designed as a commercial partnership (Shirkat ul Aqd) for the purpose of making profit from trading in real estate. Consequently, the Program is intended for the customer to fully buy out Guidance's share in the property over time, and not for the two co-owners to sell the property jointly and share the gains.

The White Paper further stipulates that should the home buyer sell earlier than the term agreed upon, the appreciation that the property will have likely earned is theirs to keep since they did all the leg work to identify the community and property. If the property sells for a loss then the shortfall is something they must consider. However, if the property depreciated so much that the shortfall is below what is considered Guidance's share in the property, Guidance incorporates a unique “non-recourse” clause that protects the seller in this case from owing the full amount to Guidance. We would consider the difference a loss on our books.

Furthermore, if the government were to impose on the co-owners to sell the property in order to make room for a road, a park or another public project the Co-ownership Agreement specifically stipulates that the two co-owners would share the gains or losses from such a forced sale according to their ownership shares. As a result, Guidance may end up with proceeds that fall short of the amount of financing it had provided, in contrast with what would be owed under a conventional mortgage loan.

The principle that the two co-owners should share in the gains and losses of their respective shares in the property applies to situations other than a sale. Consider the example of a property that suffers total destruction and cannot be repaired using available insurance proceeds. In this case again, the Co-ownership Agreement stipulates that the two co-owners would share the insurance proceeds according to their ownership shares, resulting in an outcome quite different from that of a loan.

All of the above items and questions were addressed and documented in the fatawa and white papers that were certified and amended by our board in 2002, 2005 and 2006. We can always try to facilitate a direct discussion for an extensive and more thorough analysis between your staff and our Sharia board. Our only request is for due diligence and open communication.

Islamic microfinance is becoming an increasingly popular mechanism for alleviating poverty, especially in developing countries around the world. The Islamic finance industry as a whole is expected to reach over $2 billion dollars in 2012 and is a continually growing sector due to its ethical principles and prohibition of riba (interest).

The concept of Islamic microfinance adheres to the principles of Islam and is a form of socially responsible investing. Investors who use their wealth for Islamic microfinance projects only involve themselves in halal projects which benefit the community at large. Such projects include zakat, which is charity based, or trade and industry projects to develop a country's economy.

The mechanism of lending in Islamic microfinance differs from conventional microfinance due to the prohibition of riba. Unlike conventional microfinance, Islamic microfinance offers an interest-free way to give small loans to people who are poor and in need. One key method of lending is through the Islamic financial instrument, qard'l-hasan, which is a loan that has been extended by the lender on a goodwill basis and the borrower is only required to pay the exact amount borrowed without additional charges or interest. The Quran clearly encourages Muslims to provide qard'l-hasan, or benevolent loans, to “those who need them”:

“Who is he that will give Allah qard'l-hasan? For Allah will increase it manifold to his credit.” (57:11) “If you give Allah qard al hasan… He will grant you forgiveness.” (64:17)

At a time when poverty is still prevalent around the world, there is no better solution than opting for funding which can provide benefits to a poverty-stricken community and help to rebuild economies.

Islamic microfinance gives the investor a chance to get involved in worthwhile projects which could essentially play a significant role in targeting poverty and alleviating it in many countries around the world. Islamic microfinance primarily relies upon the provision of financial services to the poor or developing regions which are subject to certain conditions laid down by Islamic jurisprudence. It represents the merging of two growing sectors: microfinance and the Islamic finance industry.

It has the potential to not only be the solution for an increased demand to help the poor  but also to combine the Islamic socially responsible principles of caring for the less fortunate with microfinance's ability to provide financial access to the poor.

Unleashing this potential could be the key to providing financial stability to millions of less privileged people who currently reject microfinance products that do not comply with Islamic law.

Many regions around the world have already created tailor-made Islamic microfinance programs, either through Islamic banks or Islamic microfinance institutions to cater for dealing with poverty.

Abdul Latif Jameel Company Community Service Programmes (ALJCSP) in the Middle East has utilized Islamic microfinance applications such as qard'l-hasan in order to provide financial support and empower low income women in the UAE so that they can endeavor to improve their standard of living.

Zubair Mughal, Chief Executive Officer, AlHuda Centre of Islamic Banking, said in a statement that, “In the wake of the current financial crisis all around the globe, Islamic microfinance has gained even more importance due to its transparency and sustainability. Islamic microfinance becomes an effective tool for poverty alleviation.” (Micro Finance Africa).

Utilizing Islamic financial instruments such as Murabahah and Musharaka to help in facilitating Islamic microfinance can not only spur the Islamic microfinancial sector but can also increase the options of Islamic finance and make it more accessible to poverty stricken countries.

While poverty in the Muslim world is widespread, Somalia is shouldering more than its fair share of the crisis. The famine which hit Somalia in July 2011 resulted in the worst food crisis that Africa has faced since 20 years. The United Nations had confirmed that famine does exist in two regions of southern Somalia, Southern Bakool and Lower Shabelle. Across the country, nearly half of the Somali population, which is currently 3.7 million people, is now experiencing a crisis of food, poverty, shelter and malnutrition.

However, if the population of Somalia had more access to financial services then they would be able to develop their economy and get it back on track. Unfortunately, the options of financial services for alleviating poverty in East Africa are either inadequate or exclusive.

Islamic microfinance has been an unprecedented way to combat poverty which may also provide the affected people of Somalia with a form of economic relief and provide a financial solution to developing countries worldwide.

By KATY BURNE

A group of 16 banks resolved a quandary that has dogged the $1 trillion Islamic financing market for nearly three decades: how to represent rates on interbank funding when Islamic principles prohibit firms from charging interest.

The banks—working with industry associations and data provider Thomson Reuters—created a reference rate called the Islamic Interbank Benchmark Rate, or IIBR, which was put into use for the first time Tuesday. The banks say the solution, which complies with Islamic moral codes, known as Shariah, lies in considering money flowing between banks as investments that depend on the performance of underlying assets, rather than as interest-bearing loans.

Scholars and bankers involved in the project say it is an industry milestone akin to the first globally issued Islamic corporate bond in 2001, or the first Islamic sovereign bond in 2002. They say the rate brings transparency to the Islamic financing process and could encourage broader use of Islamic banks.

“The establishment of the IIBR marks an important milestone in the maturation of Islamic money markets by providing an international reference rate for interbank transactions,” said Nasser Saidi, chairman of the Islamic Benchmark Committee and chief economist at the Dubai International Financial Centre, in a statement.

Islamic banks aren't allowed to earn or pay interest, yet have been using an international interest-rate benchmark—the London interbank offered rate, or Libor—since 1986. While Libor isn't compliant with Shariah, religious leaders permitted its use because there was no alternative benchmark based on socially ethical investing.

Rather than measuring interest on loans as Libor does, IIBR uses expected profits from short-term money and a forecasted return on the assets of the bank receiving funds. Both are considered investments rather than loans, and therefore interest-free.

Associated Press

Chief economist of the Dubai International Financial Centre, building above, calls the Shariah rate a 'milestone'

Sheikh Yusuf Talal Delorenzo, chairman of Thomson Reuters's Shariah committee, said the significance of IIBR is that it allows firms participating “to see the interbank market in their own terms.”

“Earnings are lawful,” he said. “What is unlawful is earnings from interest.”

Hassan Demirhan, director in the treasury department at the Islamic Development Bank, added that the introduction of an “indigenous Islamic benchmark” will prove to be a “major milestone in the growth and sustainability of the industry.”

IIBR on everything from overnight to one-year funding will be determined from rates the member banks contribute each day. The data will go through a type of cleaning called a “fixing,” where the top and bottom rates are removed and an average of the middle eight contributions is taken.

The results are blessed by a panel of Islamic banks and approved by a committee of Shariah scholars. Also involved in the launch were the Islamic Development Bank, the Accounting and Auditing Organization for Islamic Financial Institutions, the Bahrain Association of Banks and the Association of Islamic Banking Institutions Malaysia.

As of Nov. 16, the theoretical overnight IIBR would have been 0.1%, which was slightly below overnight Libor of 0.14%. Libor was cheaper over one year, however, at 0.91% versus 1.01% for IIBR.

Such differences could encourage corporate borrowers to use Islamic banks when IIBR is lower than Libor, on the theory that banks could pass savings on to customers.

“It will facilitate liquidity into the Islamic banks,” said Rushdi Siddiqui, global head of Islamic finance at Thomson Reuters in New York, who helped launched the first Islamic equity index in 1999 for Dow Jones.

Islamic banks have attracted liquidity from outside investors interested in diversification, said Mr. Siddiqui, and this will provide those funding sources with “a transparent, visible benchmark” that will encourage increased funding flows, helping to finance a wave of infrastructure projects in the region.

The development of a Shariah-compliant benchmark rate also comes amid regulatory investigations into the way the Libor rate is fixed by investment banks. Regulators have opted not to specifically endorse IIBR over other benchmarks, preferring to remain neutral, but they are aware of its creation and have supported it.

Write to Katy Burne at katy.burne@dowjones.com

The Islamic finance industry has often battled with the question: How Islamic is Islamic banking?

The question's pertinence was raised in March last year, when Sheikh Muhammad Taqi Usmani, of the Accounting and Auditing Organization for Islamic Finance Institutions (AAOIFI), a Bahrain-based regulatory institution that sets standards for the global industry, said that 85% of Sukuk, or Islamic bonds, were un-Islamic.

Usmani is the granddaddy of modern-day Islamic finance, so having him make this statement is synonymous with Adam Smith saying that free-markets are inefficient.

Because Sukuk underpin the modern-day Islamic financial system, one of its pre-eminent proponents arguing that the epicentre of the system was flawed sent shockwaves through the industry.

It also gave ammunition to the many critics who see Islamic finance as an industry more driven by cultural identity than practical problem solving: as a hodgepodge of incoherent, incomplete, impractical and irrelevant ideas.

Recognisable products

The products that modern-day Islamic bankers have created are very similar to conventional products.

So similar, in fact, that to an outside observer they could be considered the same.

Islamic banks now offer Islamic mortgages, Islamic car loans, Islamic credit cards, Islamic time deposit and guaranteed return accounts, Islamic insurance and some even offer Islamic managed and hedge funds.

This point is conceded by Samir Alamad, Sharia, or Islamic law, compliance and product development manager of the Islamic Bank of Britain.

“The industry does not want to alienate its products,” he says.

“They have to be recognisable, produce the same outcome as conventional products, but remain within the guidelines of Sharia.”

No interest

The core of Islamic economics is a prohibition on interest.

This immediately creates a problem for Islamic banks, as conventional banks charge borrowers an interest rate through which they can reward their depositors and make some profit for being the broker.

With interest ruled out it is harder to make money.

The modern Islamic banker has found a way around this prohibition, however.

As in many Islamic products, the bank enters a partnership with its depositors and invests his money in a Sharia compliant business.

The profit from this investment is then shared between the depositor and the bank after a set time.

In many cases this “profit rate” is competitive with the conventional banking system's interest rate for savers.

Lease agreements

Alternatively, an Islamic banker might enter into a lease agreement for a car or a house with an individual.

The bank would buy a vehicle outright and then lease it back to the person who wanted it, over a time period that would ensure that the capital was repaid and the bank made a profit.

Alternatively the bank would enter into a partnership with a person wanting to buy a house. The bank would buy 70% of the house, the individual 30%.

The bank then rents its share of the house back to the individual until the house is fully paid for.

The bank makes a profit on the rent, which would be higher than equivalent rents in the area, but on an annualised percentage basis, would look very much like a conventional mortgage interest rate.

To the casual observer, a spade is a spade.

Whether the product is dressed up in Arabic terminology, such as Mudarabah, or Ijarah, if it looks and feels like a mortgage, it is a mortgage and to say anything else is semantics.

Sophisticated finance

The potential wealth locked up in oil-rich Gulf states encouraged the conventional banks to enter Islamic finance.

HSBC established the Amanah Islamic Finance brand in 1998 and Deutsche Bank, Citi, UBS and Barclays quickly joined the fray, all offering interest-free products for wealthy Arabs.

However, this new generation of Islamic bankers had cut their teeth in the City and Wall Street, and were used to creating sophisticated financial products.

They often bumped heads with the Sharia scholars who authorised their products as Sharia compliant.

However, these bankers had a way of dealing with this, as one investment banker based in Dubai, working for a major Western financial organisation explains:

“We create the same type of products that we do for the conventional markets. We then phone up a Sharia scholar for a Fatwa [seal of approval, confirming the product is Shari'ah compliant].

“If he doesn't give it to us, we phone up another scholar, offer him a sum of money for his services and ask him for a Fatwa. We do this until we get Sharia compliance. Then we are free to distribute the product as Islamic.”

No consensus

This “Fatwa shopping”, which was carried out by some institutions, brings us back to the Sharia scholars.

Even these scholars do not agree all the time, which means that in some cases a product is deemed Sharia compliant in one market and not in another.

This is especially the case with Malaysian products, which are often deemed not Sharia complaint in the more austere Gulf.

“Often no rulings exist for modern day problems, such as use of narcotics,” Alamad explains.

“In Islam intoxication by wine is forbidden, but at the time of the Prophet Mohammed there was no crack cocaine.”

Modern scholars had to interpret the rules on intoxication, and the consensus was that crack should also be forbidden to Muslims, as it is a dangerous intoxicant.

“This is how we make rulings, whether in finance or societal,” Alamad says. “The consensus rules, which usually will become mandatory for all Muslims to follow, but there are some opinions and sometimes scholars are not in the consensus.”

Banking is banking

This makes it more important to be in the consensus, and so getting a favourable ruling from a leading Sharia scholar is important for a product manager.

That is why the top scholars can earn so much money – often six-figure sums for each ruling.

The most creative scholars are the ones in the most demand, says Tarek El Diwany, analyst at London-based Islamic financial consultancy Zest Advisory.

“To date, most Islamic financiers have been looking at examples of financing in Islamic history and figuring out how to apply them to today's financial products.”

But banking is banking.

It is the taking of a deposit and then using it to finance a purchase or business.

The lender pays the depositor compensation for the opportunity cost of his money, and the person borrowing the money “rents” it off the bank.

The same symbiotic relationship occurs whether it is conventional banking, ethical banking, Islamic banking or Presbyterian banking.

As Majid Dawood, chief executive of Yasaar, a UK-based Islamic finance consultancy says: “Everything that is not forbidden in the Holy Qur'an is OK.

“Yes, the industry has to evolve, but it is only 40 years old and its competing with a conventional finance system that is over 800 years old.”

Source: BBC News

CNN reports,

Just last month, Bank of America CEO Ken Lewis warned …  that he had no doubts 2009 would be an “awful year” for the credit card industry … Fearing a wave of credit card-related losses, banks have been aggressively setting aside funds to help cushion the blow. One problem, note analysts, is that banks aren't quite sure just how severe the losses will be.

….

Facing additional losses, credit card issuers are doing what they can to insulate themselves from further losses, including lowering credit limits for some cardholders, closing accounts or getting out of the business altogether.

American Express (AXP, Fortune 500) made headlines recently after it offered to pay some of its cardholders $300 if they paid off their balances and closed their accounts by the end of April.

Reuters also gives some eye opening statistics 

Currently, there is roughly $5 trillion in credit-card lines outstanding in the U.S., and a little more than $800 billion is currently drawn upon, she said.

“Lenders, regulators and politicians need to show thoughtful leadership now on this issue in order to derail what I believe will be at least a 57 percent contraction in credit-card lines,” she said.

Over the past 20 years, Americans have also grown to use their credit card as a cash-flow management tool, she said adding that 90 percent of credit-card users revolve a balance at least once a year, and over 45 percent of credit-card users revolve every month.

I have no sympathy whatsoever for these banks that are flopping during this crisis. They made billions upon billions exploiting people, especially the poor and students, turning them into life-long wage slaves [get this DVD if you can]. The problems they are facing pale in comparison to the oppression they inflicted on others. 

This is a wake up call to everyone (Muslim or not – but especially Muslims) to stop using credit cards. Unfortunately, when someone says that people immediately begin saying things like, “But it's not technically haram if you pay it off at the end of every month.”

Ok. Let's grant that it's not. That doesn't automatically mean it is the wisest and most prudent decision for you to make. Being the person who pays off their balances and avoids riba is the equivalent of the person who drinks wine every day and has never once gotten drunk in his or her life. 

If the recession doesn't wake you up, I don't know what will. This is a failed system that is founded upon something that is not only haram, but one of the most destructive sins a person can partake in. We often discuss keeping things in perspective and focusing on priorities – this is one of the top priorities of any Muslim. There are not a lot of other things that can bankrupt you in this dunya, deprive your sustenance of barakah, force you to provide for your family from haram (even if your actual income was earned through halal), be on par with committing adultery with your MOTHER, and on top of that put you at direct war with Allah(swt). 

It is time to do two things,

1. Implement the Islamic financial system in our own lives, and

2. Teach others about it. 

Implementing it in our lives is easy, but comes with a high degree of difficulty. It is more mental than anything else. It requires making up your mind to not live in debt anymore, and create a plan to pay it down. If you don't have debts, then you have no excuse to hold on to a credit card anymore. Go to the bank, take out some cash, and use it. 

More importantly, now is the time to present our solution to the rest of the world. Every single corporation in America is suddenly buckling down and being frugal. They are cutting unnecessary travel, cutting extra perks, and trying to work within their means. These are Islamic principles. 

If we want to show the world Islam can positively solve their problems, let's start getting the message out. The sad thing is, instead of preaching this message to everyone from day one, we ourselves have succumbed to chasing the American dream by digging ourselves into the hole of mortages and monthly payments that we cannot afford. This is not the way the Muslim should live. We must be the beacon of light to others, especially in these times, to show them that no matter how bad things get, insha'Allah Allah (swt) will put barakah in our rizq because we do not live outside our means. We have learned to be content with what we have been blessed with. 

Instead of showing this example to others though, it is unfortunate that for many Muslims their only hope of freedom from the shackles of debt slavery is a haram life insurance plan that will cash out only after they are 6 feet under the ground. 

Please see our previous posts on this issue for more details on these issues.

He has twice been a recipient of the Euromoney award for Best Legal Advisor in Islamic Finance (2004 and 2007) and has also received the Sheikh Mohammed Bin Rashid Al-Maktoum award for Best Legal Advisor in Islamic Finance for North America. He is currently the Chair of the Islamic Law Forum, a division of the International Law Section of the American Bar Association

I will be covering the course-work through part of the Spring semester next year (my last semester, yoo hoo). So, I thought that as I studied this material, I would share it with all of you. I know there is a lot of interest in Islamic finance, especially in light of the current financial turmoil, and interestingly Islamic financial principles take a big stab at one of the main sources of the financial collapse, debt. I touched upon this in this article.

I have to caution you that some of the stuff may be a bit too technical, but it is not necessary to grasp every word of this. Rather, I hope to give a general understanding in the simplest terms possible. If you don't understand something, ask, and I'll try to answer (“try” is a key word, because I am hardly an expert on finance myself!)

Before I embark on this journey with you all, I have been wanting to share an interesting learning from my core finance course last year. This is not part of the Islamic finance course, just something I found quite remarkable.

This revolves around the theory by two Professors, Franco Modigliani, Merton Miller, commonly known as the Miller-Modigliani theorem (M&M!) who won a Noble Prize for this. In fact, the theory itself is quite simple, and as we are learn several times in academics, many of the Noble Prize winners haven't come up with ground-breaking new research, but rather summarized/clarified/put-in-a-nutshell what was already obvious, i.e. be able to explain a phenomena that everyone kind of already knew but couldn't quite explain before!

Here's what M&M proposed:

In the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. It does not matter if the firm's capital is raised by issuing stock or selling debt. It does not matter what the firm's dividend policy is. Therefore, the Modigliani-Miller theorem is also often called the capital structure irrelevance principle. [Wiki]

The point? Debt is irrelevant. In other words, debt, by itself does not create value. In fact, an individual could mimic a company's debt structure and make the company's decision irrelevant.

So, let's say there is a company A that has 20% of debt in its capital structure (i.e. how the company is financed) with the balance 80% being equity (shares, etc.). There is another debt-free company B, with exactly the same operating performance as A (i.e. they both generate the same profits and have the same assets). An individual could then use 80% of his money to buy shares of company A, and borrow 20% from the bank, and essentially mimic company A (assume that interest rate is same for individual and company). So, in essence, B cannot differentiate itself from A by simply borrowing, because an individual investor could do the same. And then in a perfect market, where everything is known about A and B, arbitrage will prevent one company from being valued higher than the other. Miller said it best:

“Think of the firm as a gigantic tub of whole milk. The farmer can sell the whole milk as it is. Or he can separate out the cream, and sell it at a considerably higher price than the whole milk would bring.” He continues, “The Modigliani-Miller proposition says that if there were no costs of separation, (and, of course, no government dairy support program), the cream plus the skim milk would bring the same price as the whole milk.” The essence of the argument is that increasing the amount of debt (cream) lowers the value of outstanding equity (skim milk) – selling off safe cash flows to debt-holders leaves the firm with more lower valued equity, keeping the total value of the firm unchanged. Put differently, any gain from using more of what might seem to be cheaper debt is offset by the higher cost of now riskier equity. Hence, given a fixed amount of total capital, the allocation of capital between debt and equity is irrelevant because the weighted average of the two costs of capital to the firm is the same for all possible combinations of the two. [Read more here]

Okay, what's the point? Why do I find this so interesting? The point is that it is taxes, or the deductibility thereof on interest that makes debt a tool for adding value. A firm that has a constant financial structure (debt:equity ratio constant), then its value with debt can be summed up as the following (in a state where interest is tax deductible):

Original Value: Vu  (the subscript “u” is usually for value of unlevered firm = a firm that has no debt, and “l” is the value of a firm that is levered or has debt)
Borrow an amount = D
Taxes = T
New Value of Firm: Vl = Vu + TxD

So, the value of a firm that borrows an amount “D” goes up by “TxD”. This is due to tax shields. Basically, interest is tax-deductible. If you pay any interest (which as Muslims we shouldn't be), then you can subtract that from your income and basically save taxes. So, in essence there is a transfer of money from the government to you because you borrowed. And who benefits in the end? Yes, you benefit, but there is an ultimate winner, which brings me to the punch-line.

The banks are the ones who owe their economic viability and “need” on government subsidy

Now remember that a firm has to two claims against it, from its two sources of finance: the equity holders (shareholders), and the debt-holders (banks, etc.). Interestingly, while the dividends to shareholders are not tax-deductible, the interest to debt-holders is… even though they are both fundamentally returns on investment. Furthermore, the bond/debt-holders have first dibs on the money, so they get their money before any other class of financeers. And as I mentioned, all the interest that bond/debt-holders are paid, can be written off by the company, so that their after-tax interest rate is even lower. But they get no such benefit in giving dividends.

For instance, if a company has a 10% interest rate on a debt of $100. Then it has to pay $10 interest. But it can deduct that $10 from its income. If taxes were 50%, then the company now has to pay $10 x 50% = $5 less to the government. In essence then, while it paid $10 as interest, it paid $5 less to the government. So, in effect, it only gave up $5 from its coffers. Thus, its after-tax interest rate was really only 5% (which is tax times interest rate = 10% x 50% = 5%). Debt creates value for the company by reducing government claims to its income.

The entire system of tax-deductibility of interest actually has no real economic sense. I asked my Professor in class why the government would do this, what is the point? He said he didn't really know, and he especially didn't get the discrimination between interest and dividend in terms of tax-deductibility. But what is known is that the ultimate winners of interest tax-deductions are the banks. Remove the tax benefit, and banks suddenly become quite useless (according to M&M).

For Muslims, this is an intriguing conclusion. Banks, the source of so much riba, would be really quite useless if the tax rules for dividends and interest were either uniform (i.e. tax deductibility on both) or if there were no tax (like in an Islamic state). So, if perfect market symmetry existed, say in Dubai (where there is no tax), theoretically debt would add no value. Had we had no debt, wouldn't we have been so much better financially in the world these days??

Next: Introductions, “what is riba”

Related Posts:

• Economic Crisis and Wisdom of Islamic Regulations – Yaser Birjas
• Khutbah: Lessons From The Current Financial Crisis
• The Financial Meltdown and its Underpinnings of Debt
• Some Thoughts on Islamic Finance and the Mortgage Crisis
• Non-Muslims & Islamic Finance
• Islam’s Free Market Heritage

Image credit: Dinar Standard

Lessons from the financial crisis we are seeing.

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[audio http://muslimmatters.org/audio/an/AbdulNasir%20Jangda%20-%20Muslim%20Perspective%20on%20Current%20Financial%20Crisis.mp3]

Many people all over the world, especially America, are looking at the financial meltdown and wondering what is going on.

The entire “setup” and all of the associated drama is quite complex, and even the smartest financial wizards are struggling to completely understand the underpinnings, or to see the light at the end of the tunnel.

I claim no financial expertise. The few finance courses that I have taken at school only provide a glimpse into the house of cards that started unraveling this year. In order to gain a bit more insight, I turn to a book by Kevin Phillips “American Theocracy: The Perils and Politics of Radical Religion, Oil, and Borrowed money” [by radical religion, the author is referring to Christian fundamentalism, and not the Islamic bogeyman for once]. See NY Times book review here.

The book's section on “borrowed money” is almost prophetic in nature. Keep in mind that this book was published in early 2006, still in the days of a booming economy. The first line in this section of the book says it all:

“It's finally happened: Moving money around has surpassed making things as a share of the U.S. gross domestic product”.

In other words, making money on money, mostly through the instruments of riba (interest/usury), became a bigger part of the American economy than actually making tangible goods! The sectors of finance, insurance and real estate sector (FIRE–> what an appropriate acronymn!) swelled to 20% of GDP, ahead of manufacturing at 14%. Deregulation encouraged the three sectors of FIRE to be so interwoven that the combined sector became to be considered a single economic entity with assets of $60.4 trillion in 2007, up from $45.3 trillion in 2004 [Source].

Profits of the financial sector soared, from single digits in the 50s to nearly 40% of all US profits in 2004, and manufacturing followed the opposite trend, dropping from nearly 60% to single digits. What was the engine behind this growth? One word: debt! American financial companies conduct much of their business in “managing, packaging, or trading debt and credit instruments, as well as handling debt-related corporate restructurings”. Significant profits flowed from providing American households with artificial purchasing power, charging upwards of 25% interest rates on the credit card binging.  Phillips argues that this “financialization- a sign of late-stage debilitation, marked by excessive debt, great disparity between rich and poor, and unfolding economic decline, constituting the third major peril hanging over the future of the US” [in addition to oil and Christian fundamentalism]

The section of the book dealing with debt spans nearly 150 pages, definitely worth the read.  I have scanned just 2 ½ pages of some what I find to be most apt in the current situation (click here for pdf download). Phillips talks about collateralized debt obligations (CDOs), credit-default swaps (CDSs) and hedge funds, all woven together with housing and mortgage markets. If you have been following the news, you would be hearing these words repeated quite often. On pg. 378, Phillips predicted what we are seeing today:

“Between 2000 and the market bottom in 2002, when US stocks lost $7 trillion of their $15.5 trillion value, home values held up and then spurted ahead. To critics, the rescue was essentially a rebubbling. Should a credit and financial collapse follow that second stage in the manner than Volcker and others feared, stock and home prices would presumably sink together, making the second downturn the more destructive of the two”

What’s Kevin thinking now? “I told you so”

And for Muslims who kept off the mortgage binge, from taking sub-prime mortgage loans, or interest-only loans, depending on rising property prices to bring payments under control (betting on the future essentially), or for Muslims who kept their stocks clean of financial institutes that live and die off riba, and for Muslims who weaned off or never had credit card debt, the good news is that you have done much better financially, than those who said we were fools not to take the joy-ride. Yes, we all will suffer from depressing stock and home prices (if you owned either or both), but our religion saved us from far worse.

As I write this article, the government is planning another grand-scale bailout for all the financial institutes. The FIRE sector will be able to dump all their bad and “toxic” debt into a government entity. Everyday Americans (you and me) will have to shoulder the burden one way or the other. Our government continues failing in recognizing the dangers of “moral hazard“. Everything’s “just too big to fail”, which begs two questions: (1) How do you know? and (2) How did we let any entity become so big to fail? What happened to capitalism and pure market forces? One good thing in this new plan, I should mention, is the banning of short-selling for financial stocks. Short-selling involves the practice of selling a financial instrument the seller does not own, in the hope of repurchasing them later at a lower price. Islamically, selling what you do not own is forbidden, but I should caution that scholarly advice should be sought on this issue. If there are scholarly articles dealing with short-selling's prohibition or permissibility, please feel free to link in comments.

Through this new government plan still in the making, those who profited over Ponzi-type schemes will obtain a “get out of jail free”. New regulations will surely sweep in (hopefully), but the “free” market and the financial wizards will find other ways to rebubble another debt-based boom to rise from the dead. How long before the bubbles all fizzle out? Only Allah knows. What Kevin Phillips predicts is that the soaring debt (personal, corporate, government combined) will eventually take its toll on the nation. And if there is one thing that history teaches us is that no one nation dominates forever.

I know I haven't laid out the entire story here…I think enough smart people have said enough smart things. We just need to find those smart articles, read them, and understand them. So, I'll leave readers with one link for now, and I hope the smartest readers in the blogosphere (i.e. YOU) can point to other simple, lucid articles that explain the meltdown for the benefit of others, and I'll keep updating the list.

More Articles/Info:

• Comment on bloggingstocks.com

Also See:

•  The Destructive Rise of Big Finance by Kevin Phillips at Huffington Post
• BAD MONEY: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism. Book Review of Kevin Phillips's new book at NYT.
• Buy Kevin Phillips's books on Amazon: American Theocracy | Bad Money

Related Posts on MM:

• Some Thoughts on Islamic Finance and the Mortgage Crisis
• Muslim’s Guide to Debt and Money Management: Intro | Part 1 | Part 2 | Part 3 | Part 4 | Part 5 | Part 6
• The Problem with the Economic System – The Oil Price Crisis (Part 1)
• Pay Off Your Debt – Khutbah by Muhammad Faqih