Sunday, July 26, 2009

The Debts of the Lenders: Islamic Finance Predicted Credit Crisis?

Perhaps the Islamic world is on to a good thing. Under the Koran, riba (interest) is forbidden as is investing in businesses that are haram (forbidden) such as casinos and pig farmers. The purchase of expensive items is obtained through creative equity stakes by the "lender" such as buying the product or realty and selling it back to the "mortgagor/borrower" at a profit in installments (devoid of interest of course).

I do not pretend to be an expert in Islamic banking but Shar'ia compliant ( a reference to valid Koranic practices) investing is a growing trend with major institutions such as the FTSE offering a specialized index. And, as Muslims are fond of saying, their numbers comprise a significant proportion of the planet's population. One thing is for sure though, the advent of structured finance, CDS, and CDO offerings so common in the West would never be tolerated in a Shar'ia index.

But what about Dubai, a real estate speculator's paradise? Or the UAE government's questionable investments in Macau and Las Vegas casinos? Are those exceptions to the rule?

More likely they indicate that not even the best of intentions is always respected.

This article is from a Saudi publication in April 2008.

Islamic finance principles stipulate that deals must be based on tangible assets and require tight controls on debt levels, features analysts say offer some protection to investors and ensure corporate accountability.

"At the core of the current subprime crisis is the securitisation of subprime mortgages or debts, a concept that would generally not be acceptable from a shariah perspective," said Arshad Ismail, Dubai-based head of sukuk at HSBC Amanah.

He said sharia-compliant financing also avoided transactions which had an element of speculation and those that are not asset-based, thus providing investors with in-built safeguards.

These features provided early warnings to investors ahead of such corporate debacles as the collapse of Enron and WorldCom.

Both companies were part of the Dow Jones Islamic Market index, which has a screening process under which constituents with unacceptable financial ratios are removed from the benchmark. That happened to Enron and Worldcom.

"They were excluded from the DJ Islamic market index months before the crash - the high level of debt indicated ineffectiveness of control," said Aznan Hasan, sharia adviser to investment bank Aseambankers Malaysia Berhad.

Kuala Lumpur-based Hasan said that securitisation was not permissible under Islamic finance like in conventional debt and that the screening process demanded that a lender could see tangible assets and business activity from a borrower.

"You don't simply give loans to the client, allowing him to do whatever he wants, and this can have a lot of impact on credit vigilance," he said.

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