All,
I thought I’d share with you an article that my professor of ethics at CMU wrote regarding Islamic Finance. He is considered a leading authority on ethics and he sent this article to us students to give his thoughts on Islamic finance. It’s a very good read even for muslims as I think he does a great job explaining the concept behind the principles. Given the amount of islamic bashing that you hear on the media these days, I was pleasantly surprised when I received this article from him.
Please refrain from any jokes about his last name.
Islamic Investment Principles
J. N. Hooker
Tepper School of Business
A Different View of Finance
The Islamic perspective on finance warrants attention from non-Muslims for two reasons.
It offers what is probably the most highly developed ethical critique of Western financial
practices. Furthermore, a sizeable investment community follows Islamic norms.
As of 2005 there were at least 265 Islamic banks and investment firms in 40 countries.
They manage at least 260 billion USD according to the principles of Shariah (Islamic
law), and this figure grows 10-15% a year. In addition some Western banks offer Islamic
services. The Dow-Jones Islamic Market Index includes 1640 stocks in 34 countries that
have been screened according to Shariah, and the FTSE Global Islamic Index includes
944 stocks (as of 2005).
My aim is to provide a brief summary of Islamic investment principles that emphasizes
the thinking behind them. My intention is not to endorse or evaluate any of these ideas,
only to present them. My primary sources are English-language fataawa (plural of fatwa)
attached to Islamic banking websites. These are legal opinions that set forth investment
principles and reasoning that supports them.1 Islamic scholars disagree on some points,
however, and other sources may differ on the details.
Islamic investment rests on two basic principles:
- One should not make money from money, for instance by charging interest.
- One should avoid unnecessary risk.
Several specific investment practices are derived from these principles, including
guidelines for selecting a socially responsible investment portfolio.
Making Money from Money
The best known feature of Islamic finance is the prohibition against collecting interest
(riba al nasiah), even to cover inflation. Most scholars say that paying interest should
also be avoided, when possible.
Disapproval of interest, or at least excessive interest (usury), can be found in several
cultural traditions, primarily to prevent exploitation of farmers by moneylenders. Many
U.S. states have usury laws, although for practical purposes they were overridden by a
1978 Supreme Court decision.2 The Islamic prohibition against collecting interest is
based directly on the Koran (4:161, 30:39).
A fundamental Islamic argument against collecting interest begins with the premise that
human beings are custodians of wealth, not owners. Some are endowed with greater
wealth so that they can use it to benefit others. Their comfortable lifestyle should be
regarded as compensation for bearing the burden of managing assets. It makes no sense
for them to demand additional compensation by charging interest. In other words, they
should not make money merely because they have money.
It is perfectly acceptable to earn returns from investment, however. Investment is
encouraged because it is poor stewardship to let assets sit idle. Yet investors should share
the risks as well as the rewards. It is partly by taking risks that they earn the right to a
return on their investment. This means that capital gains are permissible. One can invest
in stocks and mutual funds, provided they represent companies that engage in halal
(permissible) activities.
Despite its disapproval of interest, Shariah recognizes the time value of money in the
practice of murabahah or cost-plus selling. This is illustrated by an Islamic mortgage, in
which the bank buys a house and sells it to a customer at a higher price. The customer
then pays off the bank in installments. This may appear to be equivalent to charging
interest on a mortgage loan, but there is a difference. A mortgage loan requires
additional interest if the payments are late, and less interest if the loan is paid off early,
while this is not the case for murabahah. This creates greater risk for the bank, but it is
the risk that justifies the bank’s return on its real estate investment.
The same principle argues against buying preferred stock. The dividend is fixed in most
circumstances, which results in too little risk. It is too much like earning interest.
A company should avoid liquid assets (cash, receivables, short-term notes) to the extent
possible, because they tend to earn interest. A company with too many liquid assets is
making money from money rather than from productive capital.
Unnecessary Risk
Risk is a natural and unavoidable fact of life. It is permissible and desirable to take on
risk that creates value, as when starting a business or raising a family. But taking
unnecessary risks (gharar), for example by gambling on horses, is wrong. This leads to prohibitions against options,
futures, selling short, and speculation as opposed to investment.
One argument against unnecessary risk is that it is fundamentally unfair and illogical for
wealth to be distributed on the basis of chance rather than what one deserves or needs.
To be sure, wealth is already distributed in a way that seems far from just and reasonable.
But gambling only makes things worse. By injecting unnecessary chance into the
process, we create even greater randomness and illogic. Our task as human beings is to
do just the opposite, to manage wealth to restore justice and create value.
Islamic scholarship derives from this the principle that business transactions should be
based on known prices. Buying and selling futures is prohibited because the market price
of the asset at the time of delivery is unknown. Options are prohibited for a similar
reason. Selling short is prohibited, because in this type of transaction, one sells stocks
owned by one’s broker. One then buys the stocks later, hopefully for a lower price, and
returns them to the broker along with a fee. Selling stocks one does not own creates
unnecessary risk.
Islamic thought also finds serious problems with speculation, as opposed to long-term
investment. For example, there is too much churning, or buying and selling for short-
term gains, in the stock market. This creates unnecessary volatility and risk. The stock
market should be a means of investment in productive enterprise, not a glorified casino.
In addition, capital flight from developing countries is a result of speculation where there
should be investment. The Asian financial crisis of the 1990s is a good example.
Socially Responsible Investment
Islamic law has implications for socially responsible investment (SRI), which is the
practice of investing only in ethical firms. One should not invest in firms that create
products or engage in activities that are haram (forbidden) according to Shariah. These
include liquor, pork and other haram meat, pornography, gambling, and collecting
interest.
Few firms are completely pure by these criteria, which raises the issue of how much
haram activity can be tolerated. This is normally decided on a case-by-case basis. One
strategy for dealing with this problem is purification, which requires giving to charity that
portion of one’s earnings that derive from the firm’s immoral activities. The gift should
not be counted as part of zakat, however, which is the Muslim’s obligatory gift to
charitable causes (typically 2.5% of one’s income).
The Dow-Jones and FTSE Islamic indices track stocks that pass muster by Islamic
standards, as determined by a board of scholars in each case. The Dow-Jones index
requires that the ratio of total debt to market capitalization be at most one-third (it is
actually about 8% on the average), and that the ratio of cash and interest-bearing
securities to market cap should likewise be at most one-third (again 8% on the average).
The ratio of accounts receivable to total assets should be less than 45% (it is actually
about 15%). Some of the top stocks in the index, as of 2005, were Microsoft,
ExxonMobil, Pfizer, Intel, IBM, J&J, BP, Vodafone, Glaxo Smith Kline, and Cisco
Systems. The FTSE index requires a ratio of total debt to market cap of at most one-
third. Other criteria are less clear.
Islamic Banks typically offer investment funds that are in accord with their interpretation
of Shariah. Leading funds in include the Al-Ahli funds managed by the National
Commercial Bank of Saudi Arabia, and the Al Fanar funds of the Saudi Economic
Development Company, based in Jeddah. Typical rules for such funds are that they
contain no interest-bearing securities, preferred stock, futures, options, or haram
companies (as determined by a board of advisors). The stocks represent companies that
earn less that 5% of their income in interest and for which the ratio of total debt and
liquid assets to market cap is less than 50%.