What is Islamic banking about? What are the ethical, legal, and religious nuances attached to it?
UPDATES at the end.===================================================This is going to be slightly long post. I have always been a proponent of Islamic finance and have been promoting it at all forums since my undergrad. I worked in conventional banking for 5 years and yet I kept promoting Islamic Banking. Then I did my masters in finance from one of the top business school of the world. Subsequently I have worked in Islamic investments as well as Islamic banking for almost 8 years and got a chance to see the transactions and structures used in Islamic financing up close and personal. After working on a few landmark transactions recently in structured finance, Sukuk and syndicate financing, I have come to the definite conclusion that Islamic banking as practiced today is total charade.No need to repeat the Quranic verses here but the essence of quranic injunctions is that debt should be interest free or non-profit transaction. If you want to engage in profitable transactions, do trade which entails taking equity stake. That was the argument at the prophets time that both trade and lending for profit are the same i.e. if you treat money as commodity, there is no difference between trading and interest based lending in letter of the law. However, Quran forbade against lending and approved trading. I like to think of it as difference of spirit of the law and letter of law.Anyway, my smell test is the duck test. If it looks like a duck, walks like a duck, and quacks like a duck, then it is a duck. Similarly in Islamic finance transaction, if the transaction is a debt based transaction, and then it is riba. Now matter how many commodities we trade to show it as a trading transaction.Initially it was stated that global system is interest based system and we cant just remove it and establish an Islamic system overnight. We need a mid way approach. A murabaha structure was such mid-way structure wherein by carrying out certain steps, a debt transaction would be Islamized. Probably the Islamic scholars thought they were innovating but they were following in the footsteps of the Christian clergy who gave their blessing Contractum Trinius allowing Christian merchants/bankers to bypass Christian rulings against Usury.What is even worse that instead of being considered the mid-way, faulty, stopgap arrangement, Murabaha is now considered a standard uncontroversial instrument of Islamic finance beyond reproach. A more disservice to Islamic finance hasn’t been done.The global Islamic finance industry is touted anywhere from US$1.5 trillion to US$ 4 trillion. This amount has everyone salivating and trying to come up with products to get a piece of this pie. The international bankers have been very active in this segment and sharia scholars have been very happy to guide them (for a fee of course) on how to Islamize the products available in the conventional financing.To take a small digression. Regulations are there to safeguard market participants. However, there was a huge market in regulatory arbitrage products before the credit crisis which allowed sophisticated investors to by pass the limits set up by regulators for investors protection. Lawyers and investment bankers would come with most convoluted structures to bypass legislation/regulations. Lawyers, investment bankers and accountants earned handsome fee for this business. Investors were at the losing end. Similarly there is significant tax arbitrage opportunities wherein foreign investors to US can invest through Cayman Island structures to take benefit of the loopholes in tax codes. US treasury loses out on taxes, investor loses out on expenses of capital structures/ multiple SPVs. Only people who make money are lawyers and accountants for coming up with this structure. Similarly, we have sharia arbitrage wherein a product or service may not be sharia compliant, but enough lawyers and sharia scholars bang their heads together on it for a while (and the incentive of hefty of course) they will make it a sharia compliant product.Some of the recent most used products that I have seen that are down right riba with just a lip service (read sharia fatwa) to sharia compliance are1. Tawarruq or reverse murabaha2. Wa’ad3. Sukuk4. Sharia compliant derivates (oxymoron if ever there was one)5. Profit rate swapsThere will always be people who will continue to justify one product or other and have detailed fatwas and explanations that how a certain transaction is sharia compliant but if it doesn’t pass the smell test, it is Riba.The irony of it all is that Islamic finance doesn’t ask you to change the world or come up with paradigm shifting products. The best product that fulfills the criteria of Islamic finance and has been in existence for ages is operating lease. The bank owns the equipment (there is no lending of money at all, no rotation of commodities). The bank leases/rents the equipment for its use. At the end of lease term, the bank gets the equipment back. The bank takes the risk in any increase in demand for the equipment or excess depreciation in the value of the equipment. Whereas Islamic banks and central banks in Islamic countries may look down on such transactions, banks in the west have their operating lease arms as well as operating lease portfolios in their books. As such, it is not like Islamic banks are being asked to do reinvent the wheel.The other transaction is where the bank acts a developer. For example, you bring a real estate project to a bank. Rather than giving you debt for construction financing, bank has two choices: one) if it believes in the economics of the project (it was willing to give you finance, wasn’t it) it should invest as equity holder sharing both on the upside and downside of the project when it is completed. Two) it can act as a developer i.e., sign an agreement with you to develop the project against some agreed upon costs to be paid to the bank upon delivery of the complete project or as per agreed terms. This is similar to Istisna. For banks in Islamic countries this sounds radical but western banks are already doing the similar transactions under the aegis of banking.From a depositor perspective how will this work. Depositor has two main options. To place money with the bank in current account. Or deposit money with the bank in an investment account. There can be multiple types of investment accounts to cater to the need of depositor in terms of liquidity, risk and return parameters. The lowest risk product could be in the form of a REIT fund with weekly/monthly etc liquidity. Bank on behalf of investors/depositors buys rented real estate. Depositors will get rental income from the property as return on their deposits (after bank deducts the necessary fees etc). The depositor is allowed to withdraw his investment at the NAV of the fund which can go up and down based on the real estate market performance. Similarly, investors seeking higher returns can invest in higher risk products such as equipment leases, istisna transactions etc.This is risky and requires due diligence on part of customer. Believe it or not, depositing in any bank is risky. There is this illusion among depositors that conventional bank deposits are safe. They don’t realize that banks are highly regulated organizations and carry implicit or explicit guarantees from government. Similarly, a strong regulator can easily be setup for such banks. As I said earlier, there is no need for additional regulator as such services are already regulated by existing regulators.The aforementioned idea of the bank taking a loss when property value goes down is not that radical either. Amir Sufi and Atif Mian in their award winning and critically acclaimed book House of Debt also propose a similar solution for mortgage financing. Their justification which they argue through data and statistics is that this is more fair for everyone (for the bank and mortgagee) as well as leads to less frequent or severe bubbles.Obviously lot of transactions cannot be done on Ijara or Istisna basis. The banks may actually have to engage and in real commodity transactions. Buy commodities, have warehouses to store them, act as market maker and occasionally sell them at losses. Again not a radical concept. Goldman Sachs and JP Morgan do it. In the words of Goldman Sachs chairman, “we are doing God’s work”. Obviously conventional banks are doing the transactions and leading the market which the Islamic banks should have been doing by design. But the latter and their central bankers do not even consider such transactions which are by design sharia compliant. (No fees for the sharia scholar I presume.)Does this mean that Islamic finance banks will not fail, they will not have frauds, there will not be bubbles? No, we may have all of those things because any system is only as good as the people running it and checks and balances built in to it. Why is it that when conventional banks fail and are bailed out, it is the fault of management or regulator but if an Islamic bank fails it is the fault of underlying economics.Anyway, Islamic finance is not a radical concept. There is a paper by Irving Fisher called Chicago Plan which takes you in the direction of islamic finance. (I provide few links at the bottom which show that islamic finance is already being recommended as zero fractional reserve banking in the West). All the products already exist and conventional banks already carry out such transactions. Islamic Finance is a concept which avoids debt and debt like structures.The only regulatory disadvantage it has is the tax code. Tax code treats interest (or profit on financing) payments as tax deductible compared to returns on equity. From capital structure perspective. Modgiliani and Miller proved decades ago that capital structure doesn’t make a difference on before tax basis. Now only if the tax code is modified that it doesn’t penalize equity investors and benefit debt providers.============= Update ==========Purdue is experimenting with equity finance of student loans. Atif Mian and Amir Sufi recommend a similar approach in their book for housing finance. This is an example of Islamic financing without calling it Islamic financingAt Purdue, student aid based on future earnings could revolutionize college debtHere is Matt Klein in Bloomberg talking about making banks all equity: The Best Way to Save Banking Is to Kill ItFinally, Stanford University’s John Cochrane talking against fractional reserve banking i.e. all equity funded bank