Islamic banking is the new buzzword in the finance world. It is the fastest growing segment of banking, with a net worth that exceeds US$260 billion. It operates in more than 50 countries from Africa to China, with more growth ahead. The International Organization of Securities Commissions says as many as half of the world’s 1.3 billion Muslims are expected to switch to shariah-based financing by the end of 2010.

Although Islamic banking has existed in many areas since the 1970s, it is only in the last decade that it has acquired global significance. Skyrocketing oil prices have generated unprecedented surplus cash for many Muslim countries. At the same time, the excesses of 1990s’ capitalism created a strong appetite among the world’s Muslims for more ethical financial dealings.

Putting the two together, it quickly became clear for Western banks that Islamic finance had a big future. Nowadays, the world’s biggest financial institutions, such as HSBC and Citigroup, are all developing their own comprehensive Islamic banking franchises.

The industry has become more
sophisticated than it was at its inception half a century ago. It is also much more diverse, with Malaysia and Indonesia emerging as leading centres of Islamic banking.

Non-Muslim Singapore is also assuming a prominent position as the financial go-between for wealthy Muslim investors and the hot Chinese property market.

What exactly is Islamic banking? Broadly stated, it is financial dealings based on shariah principles of ethical investment and overall financial benefit to the community. It includes a ban on investing in alcohol, tobacco and the sex industry, as well as a prohibition against lending for profit.

Accrued interest is seen as harmful to the poor, while being unearned — and, therefore, morally corruptive — to the lender.
Instead, lenders and borrowers are considered to be partners in a business, sharing in both profits and losses. Thus, a borrower is under no obligation to pay back the principal if he or she can demonstrate that that principal was lost in business, a high-risk proposition for any depositor and a serious departure from the basic principles of modern-day capitalism.

Western banks have devised their own ways of going around such restrictions. For instance, the Islamic Bank of Britain offers current and savings accounts in which the capital is invested through the buying and selling of commodities at a profit that is split among all the parties. But there still aren’t any industry-wide rules, regulations and practices governing Islamic finance, either nationally or internationally. In fact, the Basel Committee, which governs global banking, still has not introduced policies to regulate Islamic transactions. Even Saudi Arabia, a country that claims to organize the entire lives of its citizens according to Sharia law, does not have clearly defined national banking laws.

What does it actually mean?

Instead, a theological battle is raging, as Islamic scholars worldwide struggle to establish what shariah-based finance actually means. Most important, they are bitterly divided over how to interpret the prohibition against accrued interest. Radical clerics read this to mean a wholesale ban on all interest, while more moderate ones believe the ban only refers to excessive and, therefore, unnecessary interest.

The lack of comprehensive and
standardized rules and practices threatens to develop into a serious problem. Islamic banking has matured beyond being a Middle Eastern niche industry. But if it is to cross the threshold into becoming a proper arm of international banking, then its proponents need to address many issues — including the inherent paradox between the ban on interest and the hard reality of the global banking system’s dependence on money markets.

The boom in Islamic financing has benefited from the twin fortunes of high oil prices and strong performance in the commodities sector. The latter is driven by strong demand in China and the U.S., and is the primary reason why Britain’s commodities-heavy Islamic Index — which measures the performance of shariah-compliant stocks — has outperformed the FTSE 100 in three of the last five years. Neither condition is permanent, however. One can only hope that Islamic finance will have a stable and internationally agreed-upon structure in place that would allow it to continue to be profitable, once the current abnormally high level of surplus capital subsides.

The good news is that Western institutions have already started joining forces with Muslim ones in an attempt to move in the direction of greater standardization. The Basel Committee and the International Monetary Fund have helped Iran, Saudi Arabia and other Muslim countries form a regulatory board in charge of proposing a set of rules and regulations. Think-tanks and academic institutions across the U.S.
and Europe are also working in tandem with Middle Eastern universities to devise quality training in Islamic finance.

@page_break@This is all a good start, but it does not replace the need for a comprehensive and global set of rules and business practices that is integrated into the Basel Committee.

Only then will shariah-based banking become an internationally recognized arm of banking — and possibly even one day attract non-Muslims who are drawn to its focus on ethical investing. IE