Mecca for investors

PORTFOLIO POINT: Returns from investment in shariah banking are comparable to non-Islamic products, and arguably with less risk.
One of the less-noticed but more interesting outcomes of the credit crisis has been the wave of non-Muslim investors into Islamic finance. Operating parallel to the traditional Western financial system, Islamic finance offers an attractive alternative to investors and depositors seeking a safe haven from subprime contagion.

Islamic finance, also known as shariah banking (that which is consistent with Islamic law), can also be seen as an ethical alternative, with principles such as the prohibition of riba (usury), the sharing of profit and loss and the concept of wadiah, or safekeeping.

From the investor’s viewpoint, returns are comparable with similar non-Islamic products, but arguably have less risk. For the customer, costs and outcome are not too different either, but the principles of Islamic finance act as a kind of inbuilt insurance policy against some of the woes inflicting the rest of financial system. An Islamic mortgage, for instance, is arranged through the bank’s purchase of a house and the resale of that to the end-buyer. Mortgages are not repackaged into off-balance sheet debt and there are no interest rates to worry about. Payments are made in instalment with a built-in profit added on top, similar to a rent-to-buy scheme.

Nail Aykan from Muslim Community Co-operative Australia (MCCA) in Melbourne’s northern suburbs says that the main difference is shariah compliance, but Islamic mortgages can also be better for a customer’s bottom line. “In terms of rates -- interest rates versus profit rates – we tend to be a little more competitive by around 0.1% to 0.3%. But we can’t compete with limited honeymoon rates, understandably so, which tend to be around 1% cheaper, albeit for a limited time.”

Harry Senlitonga, an analyst from finance research company Cannex, says Islamic mortgages are also very competitive in markets where they are more common, such as Indonesia. “But if it was too attractive, everyone would just shift from the conventional banks. Ultimately the difference is in the shariah process, not the fees.”

The issue of shariah compliance is compelling, however. In the example of Islamic mortgages, not only is it difficult to imagine a bank actually buying a subprime property, but the arrangement, known in Arabic as murabaha, has no late payment penalties. While stricter collateral requirements apply, assets are registered to the name of the buyer throughout the transaction and if there is a default both the “borrower” and the bank receive proceeds from an auction based on the current equity.

“There is a moral guarantee, rather than just a legal guarantee,” says Mohamed Ariff, a professor of finance at Queensland’s Bond University. “And as long as the moral anchor is there, Islamic finance is very safe.”

With shariah boards acting in a supervisory capacity, in addition to central banks and prudential regulators, Islamic finance institutions have double the regulation, Ariff says.

“Shariah board members enforce two principles. The first is you cannot invest money in speculative instruments, and there is no such thing as off-balance sheet banking. Second, the banks are supposed to share profit so they don’t bet on interest. They don’t do carry trades, they don’t arbitrage currencies.”

There have been exceptions, however, with the case of a trader in Malaysia putting $400 million into futures contracts. “Like all banks, there’s operational risk, fraud risk and project risk,” Ariff says. “Islamic banking isn’t a panacea to finance and banks are by their nature greedy, so risk needs to be monitored. Even profit sharing is a double-edged sword if it’s done without shariah supervision.”

To date, however, there have been no bank failures in Islamic finance of the type seen in Western finance. While derivatives trading can hedge risks, such as currency price risk or market volatility risk, the absence of such instruments to date has been a blessing, rather than an impediment.

Islamic finance principles can, furthermore, be attractive for investors, Muslim and non-Muslim alike. In direct contrast to the infamous “models and bottles” culture of Wall Street, assets are not invested in businesses that are considered haraam (forbidden), such as alcohol, pornography or gambling (see our previous article Hard times not so nice for vice.

Ethical consumerism is also encouraged on the part of investors and deposit holders, in adherence to the tenants of Islam. So far, halal investments have been proven to work, as illustrated by an index of Shariah-compliant companies developed by financial information group FTSE.

Source: FTSE International

Besides investing in murabaha mortgage-type products, Islamic finance also has sukuk instruments (the Islamic equivalent of bonds) and takaful insurance products. Sukuk investments, which form part of the estimated $US4 trillion in Islamic assets under management, are not strictly speaking bonds, considering that interest is prohibited in the Koran, but structured certificates of title (sukuk has the same Persian root-word as cheque). Sukuk investments pay regular cash flows and can be traded in some markets such as Malaysia, although they are generally buy-and-hold style assets.

Ariff however says there’s nothing particularly new in these products. “What they’re doing is what the Arab’s practised long before Islam came into being. The Greeks and Mediterranean traders like the Phoenicians did this as well. It was lending where you shared the profit. The ships would go to another city and investors would put their money into that ship, which entitled them to a share of the profit. Columbus was also financed in the same way.”

Takaful, a system based on mutual co-operation and insurance, also has its similarities with the benevolent societies that were once popular in the West. Policyholders share the surplus and as such, takaful operates along the same principles as murabaha finance.

Unsurprisingly Islamic finance has taken off, but not only in the burgeoning markets of the Middle East. Whether holding assets in Islamic financial institutions is used as a hedge or as a core strategy, they are growing in popularity with Muslims and non-Muslims alike.

“It’s like Christians using a kosher butcher,” says Ariff. “You go there not just for religious reasons, but because you can get your meat fresh, not something that’s been sitting in cold storage for two years.

“In Malaysia, motor car and life insurance was 25% cheaper, so Hindus and Christians started shifting to Islamic insurance companies. The government was actually worried that the competitors would go bankrupt!”

Chair of banking at Monash University, Professor Michael Skully, says Islamic finance has seen resilience in the West and has used its differences to attract customers. “One of the Islamic banks in the US, Lariba, has a large proportion of its business from non-Muslims. One of the attractions is that they have a different attitude: the ethical, sharing concepts. A lot of people may not be Muslim, but they’ll say 'Gee, that makes sense to me’.”

Skully points out however that the sector hasn’t been immune completely from global economic turmoil. “You don’t have subprime mortgages on the balance sheet, but Islamic finance is not an unconnected silo.

“The returns are functions of the real economy and if the economy turns down, that affects the customers of Islamic institutions and that in turn affects the Islamic bank. They can avoid some issues, but in the end it’s the economy that has the impact.”

MCCA’s Aykan says there’s been an impact on his sector, but it hasn’t been as severe as that in the wider financial market. “It all comes down to the level of consumer confidence. We feel there has been a modest decline, but then it’s not as great as it would be in the conventional markets.”
Islamic finance is easy to enter in Australia, and Aykan says his firm does not differentiate between Muslim and non-Muslim members. “A member is a member, irrespective.”

Other companies such as Kuwait Finance House Australia, Iskan Finance and Islamic Co-operative Finance Australia also offer a range of sharia-compliant products and services. International lenders Dubai Islamic Bank, Bank Islam Malaysia and HSBC manage and market billions of dollars worth of Islamic products globally, as do Standard Chartered, JP Morgan and Citibank.

HSBC Australia says its Islamic banking brand, HSBC Amanah, is enjoying growth in the Middle East and Asia but there are no plans to bring the franchise to Australia. National Australia Bank is however exploring its options, having recently created the NAB Sheikh Fehmi El-Imam postgraduate scholarship to encourage the development of Shariah compliant financial products.

Relations between Islam and the West have been tested in recent years, but Islamic finance is one area where anyone can see the benefits. Insha'Allah (God willing), Islamic finance will continue to thrive amidst the current turmoil.