Clearing up misconceptions about Islamic finance

Today, Nizar Al Shubaily, an experienced Islamic banker, co-authors with me on Islamic finance. Although I believed that I was well versed in matters related to Islamic finance, the prevalence of misunderstood terms and concepts in the media and elsewhere have often confused matters.

Mr Al Shubaily has helped me understand a few things.  

To start off, let's take a step back and think about the meaning of interest in the financial sense. Interest is simply a fee paid on a debt, expressed as a percentage of some other number, usually the current or original amount of outstanding debt. There is nothing magical about using a percentage, or relative, amount to describe what is paid on debt as opposed to a fixed or absolute amount.

Does it matter if you say the fee is 10 per cent of an outstanding debt of US$100, versus a fee of $10? Not really. We also have to think about usury, defined as an unreasonably high interest charge or fee on a debt. Of course, it is not always clear what “unreasonably high” means in this context in terms of the general definition of usury.

Here we come to the first widespread misunderstanding in Islamic finance: it is commonly reported that “riba”, the Arabic word for payments with respect to debts (prohibited in Islam), is the equivalent of usury. But if this were true. then it would mean that if there is a level of interest on debt which is unjustified, then there must be a lower level that is justified. That is patently untrue. So what does riba, the prohibited action under Islam, actually mean?

To get to that answer we need to identify a second misunderstanding, which is that debt is prohibited in Islamic finance. On the contrary, debt is not prohibited, provided it is caused by legitimate business transactions, such as if I were to buy a car from Mr Al Shubaily and he allows me to pay him within 90 days. Debt can also be caused by services such as a ride in a taxi and by leases, such as renting of an apartment. These transactions also generate a debt that is not prohibited under Islam.

This brings us back to one of the main meanings of riba, namely the payment of fees on transactions that involve money lending.

At this point, some commentators assert that this is just window dressing. But here is a counter argument: a debt or income is generated from trading in food items and in a nearly identical transaction a debt or income is generated trading in narcotics. From a pure financial point of view, some people might not see any difference but from an ethical, moral and legal point of view, there is a world of difference.

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How a financial return is achieved is at the core of Islamic finance.

As Mr Al Shubaily helped me re-learn what I had forgotten, I saw things with a more experienced eye and I understood something important.

Much of the global commentary about Islamic finance is cynical, asserting that it is merely conventional finance with a physical asset simply backing the transactions. Mr Al Shubaily and I have a different interpretation however, that Islamic finance aims to align interests between those seeking funds and those supplying them.

By tying debt to legitimate business transactions two things happen. First, there is an aim of a better alignment of goals, as Islamic finance structures end up taking some of the direct exposure of the underlying transaction. This is effectively asset-liability matching, reducing the risk of bankruptcy due to financial – as opposed to commercial – issues.

Second, Islamic finance tends to be less tied to financial asset prices and more tied to the physical economy. This decreases the risk of financial asset bubbles. If you think about it, the price of a gold coin is going to have an upper limit. The price of bitcoin, by contrast, does not seem to have an upper limit, for the moment at least.

I'll conclude with a final macro level insight I had with my discussions with Mr Al Shubaily . The focus of most media articles and discussions regarding Islamic finance is Islamic banks. But Islamic banks really are only one part of the Islamic finance ecosystem. Islamic finance has a broad, deep and rich history in investing in the economy, going back over 1,000 years. Islamic finance has an objective to be far more comfortable taking commercial risk alongside businessmen, be it in real estate, trade or commerce.

Sabah al-Binali is an active investor and entrepreneurial leader with a track record of growing companies in the Mena region You can read more of his thoughts at al-binali.com