ISLAMIC FINANCE-An Article

[Khanzada]

FORTUNE - By Jerry Useem
June 10, 2002

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

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.

[Khanzada]

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."

[Khanzada]

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."