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Islamic finance: an introduction

The concept of applying an Islamic financial approach to western affairs has already generated hysterical headlines in some newspapers. It is only now, with the turmoil surrounding the western banking industry, that the subtleties of such a system might be considered and perhaps one day appreciated.

The description of Islamic finance as the best bits of capitalism and communism combined soon becomes apparent. It does not exist in isolation as a self-seeking entity but is part of a symbiotic process that is characterised by fairness, balance and philanthropy. Transactions are typified by the avoidance of uncertainty where deals cannot be contingent on other factors or usurped by later offers.

The Prophet Mohammed was himself a trader and was scrupulous in laying down the terms of doing business that still apply, with transparency and honesty underpinning the process. Such notions may sound old-fashioned but perhaps we are in desperate need of ancient wisdom at a time like this.

On first inspection the rules appear highly prescriptive with plenty of "haram" or forbidden items for investment or consumption. While in the Islamic faith the prohibition of alcohol, pork and pornography are well known, activities key to investment and trading, such as elements of gambling and speculation, are also illicit.

The concept of charging interest (or usury) is anathema because it takes advantage of people or projects in need of liquidity. Money should have no time value because it is simply a transactional tool. This does not mean that it is free: liquidity providers are rewarded in proportion to their contribution, albeit without guarantees or fixed rates of return.

In common with philanthropy, charity is a crucial component of Islamic finance with both obligatory and voluntary donations. Another commonality is the theme of stewardship and continuity for the next generation and beyond. It is commendable that Gulf Cooperation Council (GCC) countries are developing their infrastructure and diversifying away from oil: making provisions for the future, not squandering in the present.

Up until 2007 very few people understood the term fractional banking. This is where a bank can take a deposit and multiply it many times over to create credit. In effect, a small deposit shoulders a much larger load of debt, which can be destabilising. As long as the money is not withdrawn then the bank can reap a harvest of interest and accumulate assets over time as manufactured credit is repaid with real money.

Such superficial growth is self-destructive, creating a highly unstable structure in times of stress, like an inverted pyramid. When some of those debts lose value or default altogether in times of economic hardship then the capital base of the bank is soon swallowed up. This is the reason why banks are begging for bailouts today.

Another consequence is that the proliferation of credit simply dilutes the purchasing power of money, a process better known as inflation. The voluminous debt propagation from a procession of government bailouts will no doubt fast-forward the debasement of mainstream currencies.

The apparent prosperity fuelled by inflation is paid for by the next generation who must borrow ever-greater sums to afford basic necessities. They must also bear the tax burden of the baby boom generation who demanded gold-plated pensions. In the decades ahead both Europe and the US face many times their GDP in unfunded liabilities, requiring more tax take from a smaller number of workers.

The premise that Islamic finance provides manumission from inflation is often met with disbelief given that inflation rates in the Gulf are in double digits. This is partly because their CPI better reflects reality, but of greater significance is the peg to the US dollar, which acts like a pressure cooker for local costs. This artificial situation masks a key benefit of interest-free finance, which saves a fortune on long-term projects, thereby benefiting the taxpayer.

Islamic portfolios have a bias toward real estate and tangible assets. Joint ventures and private equity (without enormous leverage) reflect a partnership approach that shares risk and reward. Likewise in banking, the institution and customer are aligned because both will either succeed or suffer depending on the outcome.

At a time when lending has dissipated and sellers are desperate to liquidate, Islamic funds could be buyers of last resort in the property market. Likewise, viable projects and worthwhile ventures that have lost revolving credit could benefit from this pool of liquidity, as long as they are ethical.

As part of the grown up approach to finance there are no guarantees or deposit protection schemes although these must be offered where banks have a presence in western countries, to comply with local rules. However, bank lending is likely to be far more restrained and even ethical. While Islamic banks are well capitalised and conservative they are not immune from the current crisis so several have undergone defensive mergers.

Some western financiers dismiss Islamic finance as "smoke and mirrors" highlighting shortcomings in the application of LIBOR as a benchmark for yields. However, it is not a uniform system as it consists of a range of scholarly interpretations, with the more liberal in Asia and the more conservative in the Gulf.

With capital scarce at home, some bankers abuse the ambiguity by looking for loopholes; pushing products that have an Islamic label but appear somewhat suspect. While they might follow the letter of the Law they do not obey the spirit.

This is one of the tragedies of our age where many seek to milk money from the Middle East but overlook the elegance of the financial system itself. Perhaps this is the flaw of Islamic finance in that mutual trust and co-operation depend on a common philosophy or religion. While westerners are proudly "anti" many bad things we appear unsure of what we really stand for, other than our credence in consumption.

In terms of participation, families can invest directly in regional private equity deals and large "bond" issues called sukuk to share in the proceeds of infrastructure development. However, there is currently scholastic controversy as to whether a freehold constitutes true ownership, which has frozen funding. The timing could not have been worse with Dubai desperately seeking capital to continue its development.

On a smaller scale, many of the so-called balanced Islamic investment funds on offer are heavily concentrated in the Gulf. The lack of diversification makes them vulnerable to the contagion effect recently seen with capital flight from so-called frontier markets. There are, however, products in the pipeline that would allow mainstream borrowers and investors to benefit from Islamic techniques. There is no reason why such borrowing should not be available to everyone; this is, after all, the communal Islamic approach.

Families could, in tandem with Sovereign Wealth Funds, lead Islamic finance into the mainstream. By providing liquidity and interest-free financing as a role model for others to follow they could be at the forefront of a financial revolution.

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