Chapter 21

Ten Economic Benefits of Following Islamic Principles

In This Chapter

arrow Considering the needs of rich and poor alike

arrow Avoiding issues that have compromised conventional markets

arrow Encouraging thoughtful, responsible financial decisions

Lest you think that the Islamic financial industry exists only to fulfill religious obligations for the world’s Muslims, I devote this chapter to an overview of crucial ways in which Islamic principles have the potential to strengthen economies. I say potential here because the industry is so young. The concepts in this chapter are largely theoretical at this point; only time will tell how the industry’s potential economic impact plays out in reality.

tip.epsI bring up some big concepts here, and I have a small amount of space to discuss them. If economics is your thing, I encourage you to look for additional resources that delve more deeply. You’re likely to find mostly articles at this point, but I expect that the bookshelves will soon become more populated with tomes about Islamic economics.

Reducing Economic Disparity

A key difference between conventional and Islamic financial markets is that the former primarily benefit the rich, while the latter are designed to promote sharing of both wealth and risk among rich and poor. Keep in mind that Islam does not prohibit accumulating wealth. It does, however, promote awareness of — and shared responsibility for — the hardships experienced by the poor. (One of the five pillars [obligatory acts] of Islam is zakat, or giving a portion of your wealth to charity. See Chapter 2 for more.)

Think about the way conventional investment products work: The higher the risk involved in an investment, the more you stand to gain. Only someone who can afford to risk money — and potentially lose money — can participate in investments that carry the highest potential rewards. Someone who lives from paycheck to paycheck or has only modest savings can’t afford to risk losing money, so he likely doesn’t participate in such products.

In the years leading up to the 2008 financial crisis in the U.S., for example, those who made money from the risky, debt-backed securities that ultimately threatened the strength of the entire economy were mostly people and institutions that were wealthy to begin with; they used their money to generate more money. The results of their gamble weren’t pretty for anyone.

remember.epsIn addition to the accumulation of profit, Islamic financial products promote altruistic goals such as reducing economic disparity and promoting economic activity and social responsibility. Islamic investment products, for example, are built on contracts that involve shared risk among all partners, so the people who need money (to manufacture a product, for example) share both risk and profits with the people who supply money (the investors). Takaful (Islamic insurance) products, which I explain in Part VI, also aim to reduce economic disparity by requiring shared risk among all participants as well as offering shared rewards (when surplus funds go back to the participants).

Greater implementation of Islamic principles in the financial markets can result in investments that benefit people at all points on the wealth spectrum. The potential rewards of such movement — regionally, nationally, and globally — are substantial and may include less violence and greater stability.

Inviting More People into the Markets

When considering how Islamic financial products can encourage greater market participation, several key issues come into play:

check.png Having a captive market: The captive market for products based on Islamic principles is composed of people who want to adhere to the tenets of their religion and, therefore, abstain from putting money into conventional financial products, which are not sharia-compliant. The Muslim population is growing quickly; by 2030, the world will be home to approximately 2.2 billion Muslims. As these people gain easier access to financial products ranging from Islamic checking accounts to Islamic mutual funds, their participation in these financial markets will grow.

remember.epsKeep in mind that Islamic financial products are attractive to non-Muslims as well as Muslims. Anyone searching for socially responsible investments is likely to find sharia-compliant products that fit the bill.

check.png Benefiting all classes: As I note in the preceding section, rich and poor alike stand to benefit from participating in products based on Islamic principles. In the conventional market, someone lacking wealth is likely participating as a borrower (whose interest payments support the accumulation of greater wealth for the lender). In contrast, anyone with access to Islamic financial products has the potential opportunity to enter a partnership with one or more investors in an economic venture. If that person brings valuable knowledge or skills to the venture, she can seek partners with funds to support her activities, and all parties may share any wealth that accumulates (and share the risk of potential loss).

check.png Keeping credit scores in perspective: A lousy credit history doesn’t automatically slam the door to participation in Islamic financial products as it does in the conventional system, where a person’s credit-worthiness is often pivotal in decisions about whether to extend credit or a loan. In contrast, an institution offering Islamic financial products considers additional criteria when determining a person’s qualification to participate in an investment or other contract. In fact, the project’s standing in terms of sharia compliance and potential profitability is the primary factor; the customer’s financial qualification is secondary.

Promoting Simplicity and Transparency

I would never argue that Islamic financial products are simplistic; they aren’t. In this book, I illustrate basic models of financial products based on Islamic contracts so you can see how various players may interact with each other (and profit from the given venture). In real life, the model of a given financial product may look more complex than the description I offer because more than one contract and/or multiple parties may be involved.

However, I would argue that products based on Islamic principles will never become as complex and difficult to understand as some of the products that investors gamble on in the conventional markets. Here’s why:

check.png They start with stricter contracts. Islamic financial products are always based on sharia-compliant contracts (such as mudaraba, ijara, or salam) that are spelled out in literature given to the investor or participant and are required to involve little to no uncertainty.

check.png They focus on assets. Products developed based on Islamic principles always center on real assets — not speculations. That doesn’t mean investors or participants actually hold the assets in their hands, but it does mean that they know what their money is being used to purchase.

check.png They rely on scholars for guidance. A sharia board supervises every Islamic financial institution to ensure that the products offered by the institution comply with Islamic principles. A sharia board rejects any product that heads into territory so complex that an investor can’t determine the nature of the contract being used or the asset being purchased. In other words, the sharia board ensures that the Islamic firm promotes only products that are both compliant and transparent.

check.png They follow strict standards. As I explain in Chapter 3, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) promotes accounting and auditing standards that guide the transactions and reporting practices of Islamic financial institutions. Also, the Islamic Financial Services Board (IFSB) sets standards of organizational governance, transparency, and prudence. Together, these two organizations help ensure that Islamic financial institutions identify, manage, and disclose risks related to their products.

Connecting Financial Markets and Economic Activity

In a conventional market, people who have money and people who need money almost always interact with each other as lenders and borrowers. The lenders (think of credit card companies, for example) often have no idea how the borrowers are spending the money, and that information is irrelevant to them; the lender is concerned only with being paid the interest owed for the loan or line of credit (in addition to the principal).

People and institutions who participate in Islamic financial products interact as buyers and sellers or as partners in a transaction rather than as lenders and borrowers. This is true even when one of the participants is a bank or a large investment firm.

remember.epsThis distinction is crucial because it means that individuals and institutions that invest in Islamic financial products use their money to support specific economic transactions. The contracts they sign spell out what the money is being used to buy (for example, materials that a manufacturer needs to make a certain product; a commodity that will later be sold for profit; or partial ownership in an asset via a sukuk, or Islamic bond). Their investments facilitate real economic activity, which means that investors can have a direct effect on their local, regional, or national economy by supporting activity that promotes manufacturing, encourages homeownership, and more.

Linking Savings and Investment

When you put your paycheck into a conventional bank savings account, your bank promises to keep that money safe and to pay you a set amount of interest. You likely have no concern that the bank will lose your money, and you probably give little thought to how the bank uses your money. You certainly don’t look at your conventional savings account in the same way you do your investment funds.

But if you put money into an Islamic savings account, you’re putting it into an investment vehicle. As I explain in Chapters 7 and 9, an Islamic bank doesn’t guarantee a set rate of return on your savings. Therefore, you’re aware from the moment you sign the contract with the bank that it plans to actively invest your money (in sharia-compliant ways) in the effort to earn profit that it then will share with you. Your savings account is, essentially, a type of investment account (although it likely carries less risk than many other investment vehicles).

Why does this distinction matter? The West has a love/hate relationship with the concept of saving money. If consumers don’t save enough, economists lament the weakness that accompanies an economy built on the accumulation of debt. If consumers save too much, economists worry that the economy will stagnate because savings is money that’s not circulating in the real economy.

Islamic savings vehicles illustrate the concept of connecting the financial markets more closely to real economic activity. If you save money through a product in the Islamic finance system, you don’t isolate that money from economic activity the way a conventional savings account seems to do. You don’t get a guaranteed return in the Islamic account (which some people would argue is a real drawback), but as long as your bank does its job well, you benefit from profits derived from transactions that support economic transactions in the real world — not transactions that occur only on paper and only use money to make money, which is prohibited under Islamic law.

Avoiding Economic Bubbles (And Bursts)

By encouraging simplicity and transparency and tightening the link between financial markets and economy activity, Islamic finance reduces the potential for investment markets to swing to unsustainable highs and crash down to devastating lows. When investors know what their money is being used for, chances are higher that those investors understand the value of the business, project, commodity, or other asset they’re investing in. And chances are lower that they’ll buy into hype and pay inflated prices for those investments.

A paper written by Jakhongir Imamnazarov and presented at the 2011 Changing Europe Summer School argues that the Islamic financial industry has an inherent “anti-crisis code” that eliminates economic bubbles. Among his evidence, the author points to the 25-percent increase of the value of assets held within the Islamic financial industry from 2007 to 2008, when much of the world was battling the worst of the financial crisis.

An element of this “anti-crisis code” is the financial screening process Islamic investment funds employ before determining whether a company is sharia-compliant. I describe this screening process in Chapter 12; its first step involves filtering out companies that carry too much debt in comparison to their total market capitalization. In other words, a company that’s too greatly leveraged is shut out of the Islamic investment market altogether. Although some people may argue that this exclusion harms the investor (who loses the opportunity to invest in such a company), it serves a vital function by protecting the investor from bubbles — based on a company’s hypervaluation — that almost inevitably burst.

Spurring Economic Development

Most conventional financial institutions have one goal above all others: to maximize profit. An institution exists because of, and for the benefit of, its shareholders. Any of its other initiatives, including those to promote community and economic development, are tangential. In fact, governments often legislate a minimum level of institutional commitment to community and economic development because it may not otherwise occur.

Islamic financial institutions certainly aim to make profit; if they didn’t, they wouldn’t stay in business. However, the profit motive is tightly linked with other responsibilities that affect more than just shareholders. To be profitable, an Islamic institution must respect and develop strong partnerships with its customers (bank depositors, fund investors, sukuk holders, and so on). It must screen and select investments based on their compliance with sharia law as well as potential for growth and success. The bank must provide ways for money to move from the wealthy to the poor, from those seeking to fulfill the obligation of zakat to those seeking resources build a better life.

remember.epsIn other words, an Islamic financial institution is inherently committed to community and economic development; it has a broader spectrum of responsibilities than its conventional counterparts. An Islamic bank or fund generates profits through economic investment. Its profits and its partners’ profits result from economic success stories.

Encouraging Longer-Term Investment

Investors in conventional markets often make decisions based on the desire for quick returns. They try to predict the next hot industry and jump in and out at just the right times to turn a quick profit. The buy-and-hold investment philosophy seems downright quaint in an environment where people can make inexpensive online trades any hour of the day or night. Unfortunately, quick decisions aren’t always profitable, and pinpointing the next hot industry is hard. A lot of money gets wasted this way, and investors learn the hard way (if they ever learn at all) that buying and holding maybe isn’t so silly.

The Islamic approach to investment encourages a slower, more thoughtful decision-making process. After all, an Islamic investor seeks to make socially responsible choices — to avoid investment in companies that cause harm to people or the environment. Weeding out such companies is the first step in a screening process that every Islamic fund uses. The next step — eliminating companies whose financial practices are too risky — goes a long way toward reducing risk and creating greater investment stability. Intensive screenings, reduced risk, greater stability, socially responsible investment selections . . . this is not the stuff of quick action or (usually) quick returns. Investors following Islamic principles tend to follow a path that encourages more thoughtful selections and longer-term commitments.

Reducing the Impact of Harmful Products and Practices

Sharia law prohibits engaging in any transactions that support certain industries or activities that are considered harmful (to people or to the environment). For example, Muslims can’t eat pork, drink alcohol, watch pornography, or gamble. Sharia prohibits financial transactions that involve interest, speculation, or gambling, which is why Muslims can’t use most conventional financial products and must look instead to the Islamic financial industry. The list of prohibitions also includes weapons of mass destruction, cloning, and more.

By creating banking and investment products that are sharia-compliant, Islamic institutions offer Muslims opportunities to participate in the financial markets without compromising their religious principles. In addition, they also attempt to reduce the economic and societal costs associated with the harmful, prohibited products and activities.

realworldexample.epsConsider two examples: By discouraging investment in alcohol production and distribution, Islamic financial products discourage alcohol’s availability and consumption, thereby promoting improved public health. By restricting investment in the production of weapons of mass destruction, Islamic financial products discourage these weapons’ use during wartime, which helps protect civilians from the threat of widespread death and destruction. These investment decisions reflect the Islamic commitment to promoting strong, stable societies and healthy economies.

Striving for Greater Stability

The benefits I put forth in the preceding sections all lead up to this one: Globally, people are longing for greater economic stability. After years of crises and economic gloom and doom in so many countries, people want positive change. They recognize that something is inherently flawed in the conventional financial system that has let them down, and they want a system that’s more just, transparent, responsible, and sturdy.

I certainly don’t claim that following the principles of Islamic finance can solve every economic crisis or prevent future economic instability. But I do believe that the fundamental principles I discuss in this chapter and this book serve as a positive example when considering what financial reform can look like. By treating money as a medium of exchange rather than an entity with value in and of itself; by viewing profit as just one of many reasons to engage in investment activity; by serving all people in a community and not just the wealthy; by putting dollars squarely behind real economic activities that create real jobs and real products . . . by these means and more, Islamic finance promotes the type of responsibility that people everywhere are craving from their financial institutions.

If you find an error please notify us in the comments. Thank you!