The Appeal of Islamic Financial Institutions is Increasing

As strange as it may seem that there are financial institutions that are benefiting from the global financial meltdown, in the past few months Islamic Financial Institutions have been reporting significant pick up in business. Islamic financial institutions increasingly appeal to Muslim and non-Muslim customers alike. To me this shows that Adam Smith’s invisible hand is alive and well notwithstanding reports of its demise. In any functioning capitalist system, the financially strong benefit from the financially weak, even if the latter are heavily supported through the use of taxpayers money. Maybe an explanation is in order.

For illustrative purposes let us simplify the cause of the financial crisis somewhat and focus on two of the main reasons of the global credit crunch. The first cause is the immense increase in the availability and active trading of derivatives. These are financial instruments whose value is derived by the price of another asset, called the underlying. By themselves these instruments are very useful in the management of financial risk and, if applied correctly, are a very valuable tool in the arsenal available to money managers. However, over time the derivatives designed by the industry’s rocket scientists became increasingly complex and opaque. In many cases the paper held was not only highly leveraged but also unlikely to be secured by physical assets directly but by more paper. As a result, banks increasingly held securities that were far removed from the banks’ core activities, with a corresponding increase in risk.

The second cause of the credit crunch is the lack of liquidity. Up until September 2008, banks were quite content to lend to each other in the global interbank market, ie banks with excess deposits would lend their spare cash to institutions that needed more deposits to support their balance sheet. In return the lending bank receives interest from the borrowing bank. Almost overnight the bankruptcy of the New York based bulge bracket investment bank Lehman Brothers, caused in no small measure by its overexposure to some of the complex derivative instruments mentioned above, put an end to this in the middle of September 2008. The resulting lack of liquidity in the interbank market, based on the extreme risk aversion of global banks that could no longer trust each other’s balance sheets had the unwanted outcome of also stopping the global economy in its tracks.

Islamic finance is based on a number of fundamental principles. One is that making money from money, ie receiving interest, is prohibited. A corollary of this is that banks are only allowed to lend against physical collateral. Any type of derivative, and this includes collateralised debt obligations that caused much of the initial damage to investors worldwide, are regarded as paper securities with no physical backing, and are therefore off limits for Shariah complaint investors. On a more general level Islamic institutions operate on the partnership principle. Their inability to assess the requirements of the borrowers has kept them away from the problem cases of the subprime mortgages in the US. To some it was too obvious that these mortgages only benefit the arrangers rather than share the risk amongst all parties involved in the deal.

The prohibition of the use of interest when lending money barred Islamic banks from participating in the interbank market, thus leaving their liquidity situation unchanged, and not affecting their normal operations. Islamic financial institutions are thus not exposed to the liquidity crunch other banks found themselves trapped in through their reliance on the interbank market.

The overall result is that institutions run on Islamic principles have so far weathered the crisis well and are in much better shape than their conventional cousins. Depositors, Muslim or not, are beginning to see the advantages of this approach and are attracted to putting their assets with these banks. Add to this the fact that social responsibility has become a big issue with bank customers and Islamic banks are likely to continue their winning ways. They cannot, and do not, invest their customers’ funds into alcohol, gambling, pornography or tobacco related activities. This increases their appeal beyond the religious elements to a wider audience