(14) Islamic banking Islamic? (Part 1)
The contractum trinius was a legal trick used by European merchants in the Middle Ages to allow borrowing at usury, something that the Church fiercely opposed. It was a combination of three separate contracts, each of which was deemed permissible by the Church, but which together yielded a fixed rate of return from the outset.
For example, Person A might invest £100 in Person B for one year. A would then sell back to B the right to any profit over and above say £30, for a fee of £15 to be paid by B. Finally, A would insure himself against any loss of wealth by means of a third contract agreed with B at a cost to A of £5. The result of these three simultaneously agreed contracts was an interest payment of £10 on a loan of £100 made by A to B.
I had read about the contractum trinius some months before first encountering the full documentation behind an Islamic banking murabahah contract. It was the kind of contract that Person A might use in order to finance the purchase of good X from Person B. The bank would intermediate in the transaction by asking A to promise to buy good X from the bank in the event that the bank bought good X from B. With the promise made, the bank knows that if it buys good X from B it can then sell it on to A immediately. The bank would agree that A could pay for good X three months after the bank had delivered it. In return, A would agree to pay the bank a few percent more for good X than the bank had paid to B. The net effect is a fixed rate of financial return for the bank, contractually enforceable from the moment that the bank buys good X from B. Money now for more money later, with good X in between.
The above set of legal devices is nothing other than a trick to circumvent riba, a modern day Islamic contractum trinius. The fact that the text of these contracts is so difficult to come by is one shameful fact of Islamic banking. If so clean, why so secretive? The following is an excerpt from a murabahah contract that was used frequently by two major institutions during the 1990's. The 'Beneficiary' is the client that needs finance, and earlier clauses require that the Beneficiary acts as the agent of the Bank in taking delivery of the goods.
Excerpt from a Murabahah contract
Promise to Purchase the Goods
1 The Beneficiary undertakes to purchase the Goods from the Bank immediately after it has taken delivery thereof on behalf of the Bank on the terms specified in this Agreement.
2 The contract of sale of the goods to the Beneficiary shall be concluded by an exchange of telexes or telefax messages as soon as the Beneficiary has taken delivery of the Goods on behalf of the Bank.
3 If, for any reason whatsoever, the Beneficiary shall refuse or fail to take delivery of the Goods or any part thereof or shall refuse or fail to conclude the Sale Contract after taking delivery of the Goods, then the Bank shall have the right to take delivery, or cause delivery to be taken, of the Goods and shall have the right to sell, or to cause the sale of, the Goods (but without obligation on its part to do so) in a manner determined by it in its sole discretion and shall have the right to take whatever steps it deems necessary (including demand from the Guarantor to pay) to recover the difference between the price realized upon sale and the price paid by the Bank plus any other expenses incurred by it in relation to the Goods and/or any damage caused to the Bank as a result of the breach of undertaking by the Beneficiary to take delivery of the Goods or to conclude the contract of sale of the goods. "
We see here that there is even a guarantor used to ensure that the bank does not lose money on the deal in the event that the Beneficiary defaults. So much for profit-sharing. Yet the words 'profit-sharing' are to be heard constantly at all of the conferences. Some of the scholars, if pressed, will talk about moving towards more satisfactory products such as mudaraba. But then everyone goes home and works on another murabahah contract. We are told that Muslims must work within the existing banking system and change it from the inside. But we have been trying this for over forty years and nothing has changed. We are still fixing financial rates of return in advance using the Islamic triple contract.
One head of Islamic Trade Finance admitted to me over lunch not long ago that there is no practical difference between the murabahah business that he does now and the conventional letter of credit business that he used to do in his previous job. Just the labels are different. Then there's the Islamic banking department that uses interest-bearing financial instruments for the purpose of closing some of its deals. When deals are done the funds often go to lubricate the trading operations of large corporations such as BMW and General Motors. Meanwhile, in many countries, small and medium sized Muslim-owned businesses are offered no Islamic finance facilities at all. When they do finally encounter a financing proposal from an Islamic bank, many of these businessmen quickly become cynical because the financing cost is fixed at the outset of the financing agreement.
These are all signs that something has gone badly wrong in this industry. But I'm not saying that it is all the fault of the people on the inside. The Western academic establishment is at least partly responsible for the way that the Islamic financiers are thinking. For example, because Brealey and Myers have written a standard text on corporate finance, they are probably as big a force in Islamic finance as Judge Taqi Usmani. It is awfully hard to escape from the value judgements that the overwhelming mass of usury-based finance books contain. That's why an educated Muslim in Islamic finance can ask his client a shocking question such as 'what cost of finance are you looking for?' without thinking twice. He's been taught by Brealey and Myers that fixed-rate finance plays a part in any 'good' financing structure and so off he goes in search of a way to do fixed-rate finance Islamically. The possibility that fixed-rate finance may be completely incompatible with Islam in the first place may not even occur.
But there are two other reasons that prevent Islamic banks from giving up on the doubtful fixed rate products and adopting profit and loss sharing instead. The first is that the clients often prefer to take finance on a fixed rate basis. The second, more overwhelming problem, is the nature of the very business process underlying commercial banking itself.
To explain the first reason, let me tell you about a discussion I had with the Chairman of a major construction company in Asia. His company specialized in building toll roads. It had borrowed heavily at fixed interest in the middle of an economic boom. I told the Chairman that we could develop a toll revenue-sharing financing package. We would part-finance the toll road and share the toll receipts. No toll receipts, nothing for us to share. This would be good for his company because if no one used the road, there would be no financing cost. With the interest based alternative, whether the toll road was full or empty, there would still be a financing cost.
But the Chairman felt that 7% interest was a good deal and so our suggestion was not adopted. Probably this was because he knew that the toll road was going to provide profits of 30%, and there's no point paying out 30% in profit share when you can pay out 7% in interest instead, is there?
Well, the economy turned down, fewer motorists than predicted used the toll roads, but the interest still had to be paid. And so the company had to be rescued. The Financial Times commented a few days later that the rescue was required because 'interest costs exceeded toll revenues'. I kept that article because it summarized with a real life example everything that true profit-sharing would have avoided. The moral of the story is that the chairman wants to fix his financing cost because he believes his business is going to be profitable and he wants to keep most of the profit to himself. He's practicing financial leverage like all those un-Islamic textbooks tell him to.
The unfortunate fact is that even if the Chairman had given the go ahead for profit-sharing, no Islamic bank would have offered it to him. This brings me on to the second of the two reasons for the general failure of Islamic banking to provide profit-sharing finance.
Several years ago, a teacher of mine was invited to Kuwait to provide a consulting service of sorts to the executive committee of a large Islamic financial institution. On an early fact-finding tour he encountered the institution's senior Shariah scholar, an elderly man who was partly deaf, paralyzed on one side, and who had little experience of modern banking and finance. The local bankers portrayed this man as a venerated Shariah scholar, but my teacher immediately recognised him as a rubber stamper - shamefully empowered by his employers when he should have been enjoying a quiet retirement. To understand how this situation came to pass, we need only delve into the recent past. During the late 1970s and early 1980s, a small number of international Islamic banking and finance organisations came to prominence. Understandably, they were characterized by a narrow product range and in some cases a lack of credibility. For some of these companies, commercial survival came in t he form of occasional equity injections from a kindly patron and the incentive to improve business efficiency was therefore reduced. Yet it was argued that faults should be tolerated and the financial lifelines maintained in order to shield the new-born industry from a world of harsh competition. The conventional banking system could not be changed overnight, and the road of transition had to be travelled patiently.
As it turns out, patience has been of little use on this particular journey for the simple reason that we have taken the wrong road to begin with. We have arrived at a financial wonderland in which there exists an Islamic equivalent to almost all the major products of the interest-based sector, with quantitative and qualitative features that are frequently indistinguishable from them. Some have explained this situation by arguing that Islamic banking and finance can only function properly within the context of economic and social policies that are themselves Islamic. They propose that governments in the Islamic world should encourage such institutions as Waqf (endowment), mutual associations, and Zakat (the wealth levy), or at least remove the encouragements that presently exist for proscribed activities (the tax deductibility of interest for example). In my view, the most urgent of these tasks is that the Muslim world reforms its monetary system. An Islamic economy cannot be built upon un-Islamic money, and to know why this is so requires a brief digression into monetary history.
Exerpt of article:
[Courtesy:
About the author: Tarek El Diwany is a writer and consultant in Islamic banking and finance. Between 1996 and 1998 he headed the Islamic Finance department at Prebon Yamane in London, having previously established an OTC bond derivatives dealing operation for the same company. He is the author of The Problem With Interest (1997) and founder of http://www.islamic-finance.com (1997). He holds a BA Hons in Accounting & Finance from the University of Lancaster in the UK (1985) and is a founding partner of Zest Advisory LLP.]
For example, Person A might invest £100 in Person B for one year. A would then sell back to B the right to any profit over and above say £30, for a fee of £15 to be paid by B. Finally, A would insure himself against any loss of wealth by means of a third contract agreed with B at a cost to A of £5. The result of these three simultaneously agreed contracts was an interest payment of £10 on a loan of £100 made by A to B.
I had read about the contractum trinius some months before first encountering the full documentation behind an Islamic banking murabahah contract. It was the kind of contract that Person A might use in order to finance the purchase of good X from Person B. The bank would intermediate in the transaction by asking A to promise to buy good X from the bank in the event that the bank bought good X from B. With the promise made, the bank knows that if it buys good X from B it can then sell it on to A immediately. The bank would agree that A could pay for good X three months after the bank had delivered it. In return, A would agree to pay the bank a few percent more for good X than the bank had paid to B. The net effect is a fixed rate of financial return for the bank, contractually enforceable from the moment that the bank buys good X from B. Money now for more money later, with good X in between.
The above set of legal devices is nothing other than a trick to circumvent riba, a modern day Islamic contractum trinius. The fact that the text of these contracts is so difficult to come by is one shameful fact of Islamic banking. If so clean, why so secretive? The following is an excerpt from a murabahah contract that was used frequently by two major institutions during the 1990's. The 'Beneficiary' is the client that needs finance, and earlier clauses require that the Beneficiary acts as the agent of the Bank in taking delivery of the goods.
Excerpt from a Murabahah contract
Promise to Purchase the Goods
1 The Beneficiary undertakes to purchase the Goods from the Bank immediately after it has taken delivery thereof on behalf of the Bank on the terms specified in this Agreement.
2 The contract of sale of the goods to the Beneficiary shall be concluded by an exchange of telexes or telefax messages as soon as the Beneficiary has taken delivery of the Goods on behalf of the Bank.
3 If, for any reason whatsoever, the Beneficiary shall refuse or fail to take delivery of the Goods or any part thereof or shall refuse or fail to conclude the Sale Contract after taking delivery of the Goods, then the Bank shall have the right to take delivery, or cause delivery to be taken, of the Goods and shall have the right to sell, or to cause the sale of, the Goods (but without obligation on its part to do so) in a manner determined by it in its sole discretion and shall have the right to take whatever steps it deems necessary (including demand from the Guarantor to pay) to recover the difference between the price realized upon sale and the price paid by the Bank plus any other expenses incurred by it in relation to the Goods and/or any damage caused to the Bank as a result of the breach of undertaking by the Beneficiary to take delivery of the Goods or to conclude the contract of sale of the goods. "
We see here that there is even a guarantor used to ensure that the bank does not lose money on the deal in the event that the Beneficiary defaults. So much for profit-sharing. Yet the words 'profit-sharing' are to be heard constantly at all of the conferences. Some of the scholars, if pressed, will talk about moving towards more satisfactory products such as mudaraba. But then everyone goes home and works on another murabahah contract. We are told that Muslims must work within the existing banking system and change it from the inside. But we have been trying this for over forty years and nothing has changed. We are still fixing financial rates of return in advance using the Islamic triple contract.
One head of Islamic Trade Finance admitted to me over lunch not long ago that there is no practical difference between the murabahah business that he does now and the conventional letter of credit business that he used to do in his previous job. Just the labels are different. Then there's the Islamic banking department that uses interest-bearing financial instruments for the purpose of closing some of its deals. When deals are done the funds often go to lubricate the trading operations of large corporations such as BMW and General Motors. Meanwhile, in many countries, small and medium sized Muslim-owned businesses are offered no Islamic finance facilities at all. When they do finally encounter a financing proposal from an Islamic bank, many of these businessmen quickly become cynical because the financing cost is fixed at the outset of the financing agreement.
These are all signs that something has gone badly wrong in this industry. But I'm not saying that it is all the fault of the people on the inside. The Western academic establishment is at least partly responsible for the way that the Islamic financiers are thinking. For example, because Brealey and Myers have written a standard text on corporate finance, they are probably as big a force in Islamic finance as Judge Taqi Usmani. It is awfully hard to escape from the value judgements that the overwhelming mass of usury-based finance books contain. That's why an educated Muslim in Islamic finance can ask his client a shocking question such as 'what cost of finance are you looking for?' without thinking twice. He's been taught by Brealey and Myers that fixed-rate finance plays a part in any 'good' financing structure and so off he goes in search of a way to do fixed-rate finance Islamically. The possibility that fixed-rate finance may be completely incompatible with Islam in the first place may not even occur.
But there are two other reasons that prevent Islamic banks from giving up on the doubtful fixed rate products and adopting profit and loss sharing instead. The first is that the clients often prefer to take finance on a fixed rate basis. The second, more overwhelming problem, is the nature of the very business process underlying commercial banking itself.
To explain the first reason, let me tell you about a discussion I had with the Chairman of a major construction company in Asia. His company specialized in building toll roads. It had borrowed heavily at fixed interest in the middle of an economic boom. I told the Chairman that we could develop a toll revenue-sharing financing package. We would part-finance the toll road and share the toll receipts. No toll receipts, nothing for us to share. This would be good for his company because if no one used the road, there would be no financing cost. With the interest based alternative, whether the toll road was full or empty, there would still be a financing cost.
But the Chairman felt that 7% interest was a good deal and so our suggestion was not adopted. Probably this was because he knew that the toll road was going to provide profits of 30%, and there's no point paying out 30% in profit share when you can pay out 7% in interest instead, is there?
Well, the economy turned down, fewer motorists than predicted used the toll roads, but the interest still had to be paid. And so the company had to be rescued. The Financial Times commented a few days later that the rescue was required because 'interest costs exceeded toll revenues'. I kept that article because it summarized with a real life example everything that true profit-sharing would have avoided. The moral of the story is that the chairman wants to fix his financing cost because he believes his business is going to be profitable and he wants to keep most of the profit to himself. He's practicing financial leverage like all those un-Islamic textbooks tell him to.
The unfortunate fact is that even if the Chairman had given the go ahead for profit-sharing, no Islamic bank would have offered it to him. This brings me on to the second of the two reasons for the general failure of Islamic banking to provide profit-sharing finance.
Several years ago, a teacher of mine was invited to Kuwait to provide a consulting service of sorts to the executive committee of a large Islamic financial institution. On an early fact-finding tour he encountered the institution's senior Shariah scholar, an elderly man who was partly deaf, paralyzed on one side, and who had little experience of modern banking and finance. The local bankers portrayed this man as a venerated Shariah scholar, but my teacher immediately recognised him as a rubber stamper - shamefully empowered by his employers when he should have been enjoying a quiet retirement. To understand how this situation came to pass, we need only delve into the recent past. During the late 1970s and early 1980s, a small number of international Islamic banking and finance organisations came to prominence. Understandably, they were characterized by a narrow product range and in some cases a lack of credibility. For some of these companies, commercial survival came in t he form of occasional equity injections from a kindly patron and the incentive to improve business efficiency was therefore reduced. Yet it was argued that faults should be tolerated and the financial lifelines maintained in order to shield the new-born industry from a world of harsh competition. The conventional banking system could not be changed overnight, and the road of transition had to be travelled patiently.
As it turns out, patience has been of little use on this particular journey for the simple reason that we have taken the wrong road to begin with. We have arrived at a financial wonderland in which there exists an Islamic equivalent to almost all the major products of the interest-based sector, with quantitative and qualitative features that are frequently indistinguishable from them. Some have explained this situation by arguing that Islamic banking and finance can only function properly within the context of economic and social policies that are themselves Islamic. They propose that governments in the Islamic world should encourage such institutions as Waqf (endowment), mutual associations, and Zakat (the wealth levy), or at least remove the encouragements that presently exist for proscribed activities (the tax deductibility of interest for example). In my view, the most urgent of these tasks is that the Muslim world reforms its monetary system. An Islamic economy cannot be built upon un-Islamic money, and to know why this is so requires a brief digression into monetary history.
Exerpt of article:
[Courtesy:
About the author: Tarek El Diwany is a writer and consultant in Islamic banking and finance. Between 1996 and 1998 he headed the Islamic Finance department at Prebon Yamane in London, having previously established an OTC bond derivatives dealing operation for the same company. He is the author of The Problem With Interest (1997) and founder of http://www.islamic-finance.com (1997). He holds a BA Hons in Accounting & Finance from the University of Lancaster in the UK (1985) and is a founding partner of Zest Advisory LLP.]
