Thursday, June 08, 2006

FT: Islamic transactions have much in common with west

The central religious precept driving the Islamic finance industry is the idea that riba (a word that can be translated either as “interest” or “usury”) is haram (“forbidden” or “sinful”).

At first glance, this appears to rule out most aspects of modern finance. But although the Koran bans the creation of money, by money, it does allow money to be used for trading tangible assets and businesses – that can then generate a profit.

Consequently, what most Islamic financial products do is create “trading” or “business” arrangements that pay profits to investors (or lenders) from business transactions backed by tangible assets, ideally sharing risk and rewards.

Gillian Tett of FT draws on the similarities. The reality is that the difference between the two is not so much in the substance than in the concept and, importantly, purpose.

(The article is slightly old and was published on June,1.)

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I just realized FT requires subscription to view the article, so I have pasted it below :

The central religious precept driving the Islamic finance industry is the idea that riba (a word that can be translated either as “interest” or “usury”) is haram (“forbidden” or “sinful”).

At first glance, this appears to rule out most aspects of modern finance. But although the Koran bans the creation of money, by money, it does allow money to be used for trading tangible assets and businesses – that can then generate a profit.

Consequently, what most Islamic financial products do is create “trading” or “business” arrangements that pay profits to investors (or lenders) from business transactions backed by tangible assets, ideally sharing risk and rewards.

Some of these financial schemes, such as those known as mudaraba and musharaka, look similar to western-style venture capital projects. In the murabaha scheme – which is widely used in Islamic banking – an exchange of tangible goods is used to provide profits. Another popular scheme is ijara, which is similar to western-style lease financing.

The details of these schemes are often complex, since they involve special-purpose vehicles. However, in practical terms, they produce products that can be similar to western banking products – aside from the fact that the margins charged by banks are often much higher.

Take sukuks (Islamic bonds). These have maturity dates, coupons and yields. However, what differentiates sukuks is that they are backed by cash flows from tangible assets. Last year, for example, the government of Pakistan issued a $600m (€468m, £321m), five-year sovereign bond, using the tolls from a motorway to provide payments.

Ironically, some of these structures and techniques echo those that flourished in Christendom in Europe between the 12th and 15th centuries. The Christian Council of Nicea (in 325) banned the practice of usury among the clergy and in 1140 this principle was extended to church members.

However, when trade expanded in Europe from the 12th century onwards, merchants at trade fairs became adept at constructing financial transactions that avoided religious censure. Loans were sometimes considered to be “rent charges”, or interest payments were classified as “damnum emergens” (opportunity loss) or “lucrum cessens” (forgone income), which were permitted by the church. Another popular scheme was the “contractus trinius”, a three-way “partnership scheme”.

Periodically, the church sought to tighten the rules. However, the merchants proved adept at developing schemes in response to this.

Meanwhile, Jews were permitted to continue money-lending since it was presumed that they were already excommunicated.

These practices eventually died out in the 16th century, when the church loosened its ban on usury payments.

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