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Islamic and Western Banking & Finance – Distinctions with Little Difference

Islamic and Western Banking & Finance – Distinctions with Little Difference

This article is written from an economic and capital market perspective, and examines the functionality of Islamic and non-Islamic banking and finance.

In the past forty years, sharia banking, otherwise known as Islamic banking, has become a significant component of the international banking and finance system.  sharia banking, oft viewed with mystique by the western world, adheres to the core principles of sharia law.  The reality, however, is that sharia banking and finance fits neatly, and seamlessly, into the western banking paradigm without compromising the core sharia principles.

The key to understanding sharia banking and finance is to first understand that the core guiding principles of Islamic law. These principles include risk sharing, the minimization of risk (i.e., gharar), the avoidance of usury (i.e., riba), and the avoidance of products and services deemed immoral. What is not understood outside of the Islamic culture are that these guiding principles are also fundamental to several core investment styles in western banking and finance. For example, the western principles of risk and profit sharing are a part of venture capital. Reverse lender financing is effectively western financing without direct interest per se.  And, investments that consider both the return on investment as well as the greater ‘social good’ of not investing in goods or services viewed as detrimental to society such as gambling, tobacco, and alcohol is a western-style of social investing.

We will discuss each of these, and then segue to the broader picture of how sharia banking and finance may become an integral part of western banking and finance without any significant change in the established finance and banking structure.

Islamic leasing arrangements are perhaps the most innovative as to the lexicon chosen, particularly considering the same underlying leasing principles in western finance are used, with the same outcome.  This, itself, is reminiscent of an oft spoken quote by Shakespeare “What’s in a name? That which we call a rose by an other name would smell as sweet”. (Romeo and Juliet, Act II, Scene II). The western principle of leasing provides that the lessee make a fixed number of equal payments, part of which is applied to the principal of the asset and part to interest. At the end of the lease, the lessee has the option to buy the asset at a pre-set price based on the original value less principal payments made (i.e., the residual value). The interest payments, however, have no impact on the residual value.

Under sharia law, money is viewed as a measuring tool, and not as an asset per se.  Profiting from a measuring tool such as money, and not the actual asset, is prohibited (i.e., haram) under sharia law.  To apply this principle to Islamic leasing arrangements, the lessor must first own the asset during the duration of the lease.  The lessee makes payments towards the asset, the payments of which are applied towards bringing the asset to the agreed to residual value. No interest is involved per se. However, the original value of the asset is likely higher than under a western leasing arrangements.  It is this higher original value that has what would otherwise be considered imputed interest. The fundamental difference is that the term ‘interest’ is not a part of the lexicon of the agreement.

Financing home purchases under sharia law are similarly modelled to sharia compliant leasing arrangements as they omit any direct reference to interest payments.  Generally, there is a purchase of an asset (i.e., the home) at a future date through periodic principal payments.  Under sharia compliant home financing, there are typically three types of financing models: Shared Equity – Declining Balance; Lease-to-Own; and, Cost-Plus Installment purchasing.

Note, first, that under a Western home financing model the purchaser typically takes out an interest-bearing loan (mortgage) from a bank to purchase the house from the seller with title transferred to the purchaser.  The purchaser pays the bank (lender) interest along with principal payments that go towards the eventual removal of a lien the bank places against the home.  During this time, the bank holds a lien on the property until it receives both interest and principal payments in full.  Failure to pay the interest and principal allows the bank to take title of the home from the purchaser.

As noted, however, interest is not allowed under sharia law (money is a measuring tool, not an asset). As such, sharia compliant home financing uses different home purchasing models, though effectively with the same monetary outcome as western home financing.

Under the Shared Equity – Declining Balance home financing model, the bank owns the home and transfers partial ownership to the purchaser on each principal payment made by the purchaser. While there is no interest per se, the agreed to original value of the home is typically higher than under a western home financing model, and is considered a profit to the bank. It is that higher value that is effectively the same as the interest that would otherwise be paid to a western bank (lender).  The Lease-to-Own model is similar, as it first affords the purchaser the right to live in the home and have an option to purchase the home from the bank at a future date, with the lease payments made reducing the original agreed to value.  However, as with the Shared Equity – Declining Balance model, the original agreed to price of the home is typically higher than under a western model.  This difference is a profit to the bank that otherwise is interest under a western model.

The last financing model is the Cost-Plus Installment model.  Under this model, an intermediary typically purchases the home then sells it to the homebuyer at a higher price. The homebuyer may purchase the home from the intermediary in one installment, or in several installments.  The fundamental difference is that there is no interest involved per se.  However, one may reasonably argue that the profit gained by the intermediary is effectively interest paid to a lender under a western model. The distinction between sharia compliant home financing and western home financing is effectively a distinction without a difference.

Other areas where sharia compliant investing fits neatly into western banking and finance include investments in the equity and debt markets. Here, however, there are clear distinctions as to what is permissible and what is not permissible. For example, investors may invest in equity of both private and public companies.  However, similar to western-style Social Investing models, companies that provide products or services such as alcohol, tobacco, or gambling, are prohibited investments.  Likewise, companies that have interest-bearing debt that exceed limit exceptions as provided by Islamic scholars are also prohibited investments.  Investors may also invest in profit-loss sharing contracts.  These contracts are held by banks that pool investors money along with the banks funds, and invests in sharia compliant mutual funds.  This is permissible as the principles of risk sharing and minimizing risk are met.

In closing, sharia compliant banking and finance clearly fits into many components of western banking and finance without compromising the core principles of Islamic law. As both financiers and investors alike understand this, sharia compliant banking may readily continue to become an integral part of the International banking and finance markets without any significant change in western financing models, nor any compromise of core principles of Islamic law. Likewise, western banks and financiers may readily open up, with subtle modifications, their products and services to a large pool of Islamic compliant investors, providing for even greater opportunity and liquidity to sharia compliant investors.

 

Edward Grey is a Managing Director at Watts Capital, LLC, a Manhattan, N.Y. based Wealth Management and Investment Banking firm.  Mr. Grey advises both domestic and MENA region companies with a focus on biotechnology, genomics, and bioinformatics. Mr. Grey is a graduate of Carnegie Mellon University, where he received a Bachelors of Science for both Economics and Industrial Management, and Vermont Law School, where he received the Award of Academic Excellence for Law & Economics. Mr. Grey is also a Level II Candidate for the CFA designation. 

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