islamicbanker.com

Articles on Islamic banking, February 2009

Uncertainty and fear can make the most ardent of investors question their philosophy. In a year when most market adages have been thrown out of the window by advocates of the free market, at least one has never been more appropriate: financial markets are a great leveller.

This is eloquently captured by Nassim Nicholas Taleb, who has established himself as a leading authority on the current crisis, in his analysis on uncertainty. There are two types of businesses: those protected from major surprises and those that can lose everything in matter of minutes. The income of a dentist, although it can be significant, is unlikely to vary greatly over a given period. However, the income of a bank derivatives trader - and in some cases the income of the whole bank - can disappear rapidly. Taleb, described by The Guardian as the "new sage of Wall Street", refers to the latter scenario as "negative Black Swans".

Indeed, financial history, from the Latin American debt crisis of the early 1980s to the Asian financial crisis in 1997, teaches us many lessons about "Black Swan" shocks. By far the biggest lesson is our own extraordinary hubris, our tendency to believe that we can accurately and consistently predict the future.

As conventional economists go back to the drawing board, proponents of Islamic finance have been sharpening their pencils. Traditionally Islamic scholars have pointed out many non-compliant practises in global stocks - the level of interest and debt being two of the main examples - which have limited the growth of the industry. However, more recently, scholars have taken a practical view, with more room for compromise.

The process for investing in Sharia stocks is certainly unorthodox, with the initial emphasis placed on the ethics rather than profits. A Sharia portfolio manager firstly investigates the sectors (industry screen) that potentially have a negative impact on society. Conventional banks, insurance companies, tobacco firms, entertainment businesses and weapons manufacturers are all excluded from the portfolio.

The next step involves a closer look at specific companies (security screen), to ensure that they comply with certain Islamic principles. Scholars at the leading providers of Islamic market indices focus on three key ratios:

1.      Total debt / market capitalization (less than 33%)

2.      Interest income / total revenue  (less than 5%)

3.      Accounts receivables / total assets (less than 45%)

To ensure continued compliance to the industry and security screens, a quarterly review of securities is undertaken.

As the markets continue to be gripped by fear, many commentators are recognising Islamic banking as an industry on the rise. The is demonstrated by the growth in the number of qualifications on Islamic finance and their uptake, with the most recent example being a master's degree in investment banking and Islamic finance, offered by the University of Reading.

As a result of globalisation, industries across the world have never been closer. More specifically, some of the largest names in Islamic banking are in fact traditionally, conventional banks. The likes of HSBC, Barclays and Citigroup are all major players in Islamic banking through "Islamic windows". Consequently, what happens in the conventional world will inevitably have ramifications on Islamic banking.

Certainly, recent Islamic market performance has been lacklustre, with the Dow Jones Islamic Market Titans Index, which charts the performance of leading global Islamic stocks, dropping by 5 percent in the last 3 months. Analysts point out that Islamic banking has not escaped from the havoc caused by the credit crisis. Some have gone even further, pointing the finger at the AAOIFI - the global Islamic finance standards body - which has recently raised concerns about the Sharia compliance of certain instruments. 

However, although the Islamic Market Titans index has fallen by 5 percent, the leading conventional index, S&P500, has plummeted by 10% in 3 months. Indeed, the ruling by Shaykh Usmani could be a blessing in disguise. Islamic banking needs to learn lessons from the credit crisis and one of the key lessons is that simply following the markets blindly will cause long-term damage. It is only the willingness and confidence of Sharia scholars in taking on the practitioners that will tame the "black Swan".