Skip to content

Islamic finance: More than meets the eye

September 25, 2009

The supply and accessibility of financial capital democratised capitalism. Business owners, willing to work hard and with a bankable idea, were not short of finance. It was the existence of such markets that bankrolled railway projects in Elizabethan times. After all, railroad tracks won’t have been invented if there was no way to raise money to build them.

Walter Bagehot, the first editor of The Economist, in his 1873 book Lombard Street (an essay on England’s money markets in the 19th century) noted that “in all but the rarest of times, money can be always obtained upon good security, or upon decent prospects of probable gain.” It was, he continued, a “luxury which no country has ever enjoyed with even comparable equality before.”

Making money work

In 21st century Africa, ease of getting credit isn’t common. To be sure, profitable businesses abound. However, a distrust of or absence of institutions: legal and financial, prevent informal businesses from accessing formal credit. Conversely, it locks out the hoards of money circulating within the informal sector. (In August 2009, money supply data from CBN showed that 4.51 trillion naira was in public hands, the banks were holding 9.5 trillion naira, loans to the private sector was 9.7 trillion naira, the amount of currency in circulation was 1.02 trillion naira and currency outside banks was 760.9 billion naira).

To make finance work for Africa, in simplistic terms, means getting people to save in banks rather than stuffing wads of money under their mattresses. In Africa, until a decade ago, the persistent failure of formal and semiformal finance to advance left “a fragmented and dualistic financial system stubbornly in place” according to Making Finance Work for Africa, a 2007 World Bank report by Patrick Honohan and Thorsten Beck. However, signs of financial progress: diversification of activities, depth of lending, increase of reach with new products and new technologies (in Kenya and Uganda mobile money is growing rapidly) and a budding microfinance industry, are showing.

Yet still, there’s a long way to go. On all counts finance in Africa is shallow. The percentage of deposits offshore, low credit numbers, banking spreads (a function of profits, overhead costs and lack of competition), liquidity of the capital market, deposits mobilised and credit extended, suggest so. Also, access to formal finance by small firms and households, especially in rural areas, is still limited.

Supportive policies that spur the depth and breadth of financial markets increase access and contribute to growth. Such policies will empower entrepreneurs by lowering entry barriers; reduce risks to savers and borrowers and thus benefit the economy at large. Higher levels of output and productivity of, say, a farmer, due to access to necessary finance will increase employment, improve prices, quality of services and reduce the stranglehold of established monopolies.

All told, this assumes that infrastructure, to support the increase in output, is already in place. Where infrastructure is sclerotic, like in Nigeria, a financial system that effectively allocates and reallocates funds to such sectors is indispensable. A better governed financial system that will make banks function as they should is thus a desirable aftermath of the ongoing reform.

Good governance – of financial institutions and their regulators – is the touchstone of success in reforming Nigeria’s financial system. “Strong financial systems are built on good governance.” It engenders trust in the system. Trust that makes individuals and firms rely on banks for either keeping their money or for funding. In Nigeria we’re yet to scratch the surface.

Where the money is

A little over a quarter of Nigeria’s bankable population operate a bank account; significant proportions are also Muslims whose faith forbids interest (riba) bearing investments. Thus the Central Bank of Nigeria (CBN) plans to make Islamic finance a significant aspect of Nigeria’s financial landscape. This can be viewed through the lens of Sanusi Lamido, the CBN governor. His twin objectives are: “restoring confidence in the financial system” and “playing an important role as an agent for development”.

Doubtless, in a country notorious for religious violence, talks of a banking system based on particular religion will raise hairs. Understandable but unfortunate. This is because modern banking as we know it is being suited to religion. Non-religiosity isn’t the inevitable consequence of modernity. On the contrary, religion and modern banking are compatible. Islamic finance is one such manifestation.

Even before the global financial crisis accentuated two facts identified by Prof Joseph Stiglitz, a co-winner of the 2001 Nobel Prize for Economics. Firstly, “Those who would spend don’t have the money, and those with the money aren’t spending.” Secondly, “the hoards of liquid money to help bail out the world lie in Asia and the Middle East. But global institutions do not reflect these new realities.”

According to Mckinsey Global Institute (MGI), “oil-rich countries and Asian central banks are now among the world’s largest sources of capital.” In 2006, along with hedge funds and private-equity firms, McKinsey referred to them as “the new power brokers”. Petrodollars from oil booms: the 1970s, the 1990s and the past five years, needs safekeeping. And few traditional investments are shari’a compliant.

By the end of 2006, “The Gulf Cooperation Council (GCC) states – Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates (UAE) – had foreign assets of $1.6 trillion to $2 trillion.” During the same period, oil exporters (Nigeria included) collectively owned $3.4 trillion to $3.8 trillion in foreign financial assets.

However, in a recent update to the report, MGI reckons that the 2008 crisis has altered the fortunes of the power brokers and their paths have diverged. Though all four fared better than other investors; “petrodollar and Asian sovereign investors are more influential than ever, while the rapid growth of hedge funds and private-equity firms has halted abruptly”. The research further notes “that foreign assets of petrodollar investors will remain larger than of those held by the other three classes of power brokers over the next five years.”

Banking on Shari’a

Paragons of western-style finance, multinational banks in the City of London and on Wall Street in New York, have realised this. Much of the innovations to provide financial instruments compatible with shari’a law have come from non-Muslim western financiers. Banks like Deutsche Bank, HSBC and Citigroup have shari’a-compliant units that are picking lucrative project finance deals to fund the Gulf region’s sprawling infrastructure.

No less, some western countries are making efforts to attract foreign investment from the GCC states. Stichting Sachsen-Anhalt Trust, a financing subsidiary of Saxony-Anhalt, a state in Germany, issued a €100 million five-year sukuk (asset-backed bonds that comply with shari’a) in 2004.

Christopher Watts, in a survey on Islamic finance, says that “The UK’s first standalone Shari’a-compliant bank opened its doors in 2004; two others have followed; another is on the way. (All are backed by Middle Eastern institutions.) And in April this year the London Stock Exchange listed its maiden sukuk, adding much-needed depth and liquidity to the market.”

A keen race, to become the global capital of Islamic finance, is currently on. The UK and France are writing legislation to smooth out tax and legal bumps to Islamic banking. One aftermath of the crisis: huge stimulus packages being channelled into infrastructure, have made the $700 billion (and growing) industry very attractive to these developed economies.

More so, Islamic finance, unlike western-style finance in its pre-crisis go-go years, does not encourage credit and debt products. Rather, shari’a-compliant finance products are based on an income-sharing notion. A far cry from the huge leverage and outlandish bonuses that typified Wall Street and the City of London banks before the global slowdown.

Islamic finance presents an alternative paradigm to banking as we know it. Its requirement of asset-backed transactions builds greater linkages with the real economy. Funding of infrastructure, say, road and bridges promote economic and social development. This form of banking is also considered as “viable and ethical” – based on principles akin to ethical investing and corporate social responsibility.  Dealing in morally and socially injurious industries is prohibited.

What is certain is that Islamic banking is no longer a business operating on the fringes of global finance.  It has gone from being a niche business to a very much mainstream part of the global banking system.

Out of Africa, always something new

Fr Joseph Kenny OP, an American priest based in Ibadan, notes that “Islamic banking is another option, a form of investment. A non-interest banking option that allows you share in some of the profits or loss of an investment.” Fr Kenny, a Dominican and professor of Islam and Arabic studies who has lived in Nigeria for 45 years, reiterated that “It’s just an option that maybe should be tried. Sanusi, being a banker himself, maybe sees some merit in it.”

Islamic credit transactions are structured as partnerships wherein risk and profit are shared.[1] Market interest rates are used as the basis of profit margins. Better still, sukuk are issued. By issuing sukuk, Islamic banking can get the best of both worlds: attracting longer term deposits to finance infrastructure projects. This is more compatible with the risk and profit sharing notion – Islamic financial instruments have to be backed by hard assets. The foray of Islamic finance, to fund Nigeria’s yawning infrastructure deficit (Nigeria’s power sector is estimated to need $10 billion per year), couldn’t be better timed.

Besides, the GCC states and South-East Asia are the two of the fastest growing regions in the world. Both have a combined Muslim population of 410 million. To boot, recent research by Pew Research Center estimates that there are 1.57 billion Muslims in the world. In other words, one in four persons is a Muslim. Most live in Asia and Indonesia, with 203m Muslims has the largest share. India’s 160m Muslim population is third largest. In Russia there are 16.5m Muslims, while according to official figures, there are 20m Muslims in China. Mainly among the Hui and Uighur peoples in Ningxia and Xinjiang Provinces. In God is Back: How the Global Rise of Faith is changing the World, John Micklethwait, editor-in-chief of The Economist and Adrian Wooldridge, management editor and Schumpeter columnist, also with The Economist point out that “By 2050, China could well be the world’s biggest Muslim nation as well as its biggest Christian one.”

Note that India, China and Russia form part of the Bric countries. Indonesia, based on its impressive pace of growth, is said to be vying to be included among this group of fast growing emerging economies. As these economies grow, increase in savings will sniff out profitable investments abroad.[2] Clearly, such money will only be invested in, say, sukuk financed infrastructure projects.[3]

Locally established Islamic banks are already looking to get a piece of the action, both at home and abroad. For instance, the UAE’s Sharjah Electricity and Water Authority (SEWA), raised $350 million, the region’s first sukuk, for a power generation and desalination plant. Globally, Africa is a beguiling destination.

The Economist in an article Turning towards Mecca reported that “Moody’s, a credit-rating agency, reckons that although Islamic finance was worth a puny $18 billion at the end of last year, its potential is close to $235 billion—about half what it estimates as the GDP of Africa’s Muslim population.”  A once middling market is burgeoning with the aid of oil-rich Gulf States seeking profitable investments.

Africa’s first sukuk was issued by a Sudanese cement firm. “Reportedly, the government also tapped the market in January—selling bonds to Gulf investors to sidestep American economic sanctions over the massacres in Darfur.”

Albaraka, South Africa’s only Islamic bank was set up in 1989. Kenya licensed two Islamic banks: Gulf African Bank and First Community Bank, in 2008. “In Kenya Barclays was the first to offer an Islamic bank account appropriately named La Riba, meaning no interest.” ABSA, a South African bank, started an Islamic banking division in 2006. It comes with the frills of modern banking: phone, internet and branch banking.

Nonetheless, there are issues. Islamic finance is bound to shari’a law and thus investments must be suited to the tenets of Islam. Three rules stand Islamic finance out. First, investment in gambling, alcohol, armaments, pornography, tobacco and pig meat industries is forbidden. Second, investments must be non-interest bearing. Third, excessive risk taking and uncertainty must be avoided.

In addition there are controversial interpretations and criticisms. Some Muslim countries differ on what constitutes shari’a-compliant financial products. Therefore, the CBN was right to note that “an adequate regulatory and supervisory framework for the effective operation of the Islamic bank”[4] is required. No less is the need to enlighten the public about its benefits. This must address unmerited allegations of a religious agenda. To Fr Kenny, there is neither an agenda nor a hidden threat.

However, to prove amenable to Nigerians, the CBN must admit that the timing of the announcement may have been unwise; granted that plans were already in place. Yet coming just after the furore over the sack of the five CEOs and recapitalisation of the banks, it was bound to come under flak. And thus leaves the CBN open to accusations. Renewed confidence in the financial sector and economic development are wanted, but not at the expense of doubt in the regulatory body.

[1] Other Islamic finance products: ijara (leasing), murabaha (a contract to purchase and resell an underlying good including a mark-up) and musharaka (equivalent to a co-ownership/partnership financing structure)

[2] Arcapita BankB.S.C., Gulf Finance House, and Unicorn Investment Bank, all based in Bahrain, are the best representatives of this new generation of financial intermediaries, capturing the capital that institutions and wealthy families are seeking to invest and recycling it in high-yielding industrial, real estate, and infrastructure projects. Islamic Finance To Expand Slowly But Surely In The Maghreb, a commentary report by Standard & Poor’s, April 23rd 2007

[3] Principal asset classes: tourism, real estate and infrastructure, are attractive sectors for Islamic finance. To qualify as shari’a-compliant, financial instruments must be backed by tangible assets. Thus hotels, resorts, residential and commercial real estate, roads, bridges, power plants and other like projects will naturally get financed.

[4] The International Financial Services Board (IFSB), a Malaysia-based “club” of central banks in Muslim countries serves as a transnational regulatory body. Its aim is to help resolve disputes over what is shari’a-compliant, regulate Islamic financial services and standardise Islamic finance to suit western banking rules like Basel 2.

No comments yet

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s

%d bloggers like this: