Islamic finance has been one of the fastest-growing areas of the global financial services industry over the last decade. This growth, estimated at 15 percent annually over the last three years, has been primarily driven by vast inflows of petrodollars, the search by Western banks for high-margin businesses, and widespread innovation in Islamic financial engineering. However, Islamic financial institutions have not achieved the same degree of success in creating regulatory environments conducive to greater innovation and development of Islamic capital markets. Standardized regulation is critical to the future growth of Islamic finance.
The State of Islamic Finance
Interest is at the foundation of conventional financial systems. Payments on interest compensate creditors for both the time value of money and default risk. However, interest is prohibited under Shari'ah, or Islamic law: the Qu'ran states, "And that which you give in gift, in order that it may increase from other people's property, has no increase with Allah." It also declares, "We have prepared for those among men who reject faith a grievous punishment."
For a devout Muslim, all fixed income instruments from mortgages to interest rate swaps are clearly haram, or forbidden. Additionally, Shari'ah bans excessive gharar, or risk. This condition is more ambiguous than the prohibition of riba. For example, an exporter could use currency options to hedge foreign exchange risk, while a speculator could use the same options to make bets on exchange rates. In the former situation, options are used to decrease risk, while in the latter, options are used to increase risk. Even in this simple example, Shari'ah scholars could (and do) have differing opinions. Clearly, the absence of standardized regulation can lead to significant confusion among investors.
Despite the bans on riba and gharar, Islamic banks have developed Shari'ah-compliant financial products from loans and insurance to equity funds and exotic derivatives. These financial products often take the form of profit-sharing agreements between a "debtor" and a "creditor." For example, in mudarabah, sometimes called participation financing, an entrepreneur asks a bank to provide capital; profits are shared between the entrepreneur and the bank according to an agreed ratio. Profit sharing continues until the "loan" has been repaid.
On the other hand, in murabahah, a bank can purchase a good for a customer and sell that good to the customer at an above-market price that is equivalent to the market price plus the amount the bank would have earned from interest. The customer then pays the bank in installments, just as if he or she had taken a conventional loan. However, the bank cannot charge the customer extra money for late payments, so instead the bank has custody of the good until full payment has been received.
Each financial product must be approved by Shari'ah advisory committees or consultants. Because it is nearly impossible for any product to be approved by every Shari'ah scholar in Islamic finance, banks traditionally focus on some target group or appeal to as many people as possible. Some Islamic scholars have remained opposed to Islamic finance, maintaining that the industry's techniques are simply legal fudges. They draw comparisons to contractum trinius, a method European bankers used during the Middle Ages to circumvent the prohibition of usury. A banker would invest the amount of money required by a borrower and then purchase insurance for the investment from the borrower. Finally, the lender would sell the borrower the right to any profit made on some percentage of the investment. The three contracts used in contractum trinius, investment, insurance, and sale of profit, were individually permitted; put together, they behaved like an interest-bearing loan.
Islamic finance is one of the most rapidly growing areas of international finance today. …