Islamic finance has much to learn from the west

By Muhammad Saleem *

Proponents of Islamic finance maintain that as the Koran prohibits interest all financing must be done on a profit and loss sharing basis. In spite of all the lofty rhetoric, in practice no more than 5 per cent of Islamic financing is done this way.

Instead, Islamic banks use a structure called murabaha, or cost plus pre-determined profit, for the vast majority of their finance deals. Remarkably, the « profit  » for an Islamic bank in a murabaha transaction and the interest a conventional bank would have charged on the same transaction happen to be exactly the same. Indeed, Islamic banks in determining their « profit  » even quote the rate as a margin over Libor or other similar indices.

Murabaha was a crude trading practice designed for transactions between real sellers and real buyers involving physical goods. By structuring a financing transaction while disguising it as a trading transaction – and charging interest concealed in Islamic garb – Islamic banks turn the entire enterprise into a charade.

Other modes of financing are just as dubious. Take Islamic house finance, structured as a lease: lease payments are equal to interest that a conventional bank would charge on a home mortgage loan. Sukuks, or Islamic bonds, are similar in many respects to murabaha and just as tainted. Brandishing a fatwa from a scholar of sharia law (who, like mercenaries, are sometimes for sale at the right price), blessing the structure does not absolve the bankers from the responsibility of meeting the spirit of the sharia.

The real problem with the Islamic finance industry is that despite a 30-year history and current assets of about $300bn they have yet to add any value. Islamic banks have not created any new jobs (employment at Islamic banks does not count), financed new inventions or innovations or made the Islamic communities more just and equitable. The smoke and mirrors Islamic finance industry appears to be all about creating financial structures to comply with the letter of the law, not the spirit and intent of the Koran.

Islamic banks need to move away from the deceptive modes of financing they currently use and step towards the American style of venture capital. This has two advantages. First, the stated principles of Islamic banking – favouring profit and loss sharing over interest – are very similar to the financing techniques used by the venture capital industry, especially in the US. These private equity groups are the real Islamic finance, the genuine article. Second, by providing funds to entrepreneurs with bright ideas, the banks can assist in promoting innovation, invention and creation of new jobs and industries.

The ironic thing is that although the US is not an « Islamic country « , more authentic and genuine sharia compliant financing is done in the US than in all the Islamic countries combined. That is because American venture capital groups annually provide about $25bn in capital financing to entrepreneurs, scientists and engineers with new ideas. As a consequence of the availability of this type of financing the venture capital industry in the US has given birth and nurtured scores of Silicon Valley companies, including modern day icons such as HP, Cisco, Intel, Sun Micro Systems, Apple, Netscape, Ebay, and Google. All were created in the past 30 years or so from ideas grounded in science and technology. Scientists and engineers came up with the ideas, innovations and inventions while the venture capital industry provided the capital on a partnership basis. Millions of new jobs have been created as a result.

At one time – from AD750 to about AD1100 – it was the Muslim world that was making advances in science and technology, because of the availability of risk capital (from rich people or sponsorship from the rulers) and respect for education, scholarship, discovery and innovation. But nothing of consequence has been invented in the Islamic world for hundreds of years.

The west’s renaissance partly came as a result of learning from the Islamic world. Now it is the Islamic world that needs to learn from the west, especially borrowing those ideas that are both consistent with its own beliefs and able to contribute to economic and scientific development. Venture capital is clearly such an idea. By becoming more like venture capital groups, the Islamic banks can practice real Islamic finance while helping the Islamic community to rediscover its tradition of invention and innovation.

* The writer is a former international banker and the author of « Islamic Banking: A $300 billion Deception ». Article first published Jan 18, 2007 on FT.com