The philosophy of Islamic finance

After observing recent US political disagreements and entertaining possibilities of macroeconomic fallout, once again I was reminded of my recent bias to be bullish the microeconomy; i.e., companies. While the macro outcomes of what might be decades of politically-motivated economic risks in the US can certainly lead to company-specific damage, one could consider that post-2007 uncertainty has geared companies in a way that readies them for receding economic growth.

I hope that didn't sound glum, I think it's a very good thing. While some tech companies are booming and US investment banks have changed their attitudes little (on the watch of lazy regulation) since 2007, many industrial companies have not only had to focus on deleveraging and structuring defensive balance sheets, but also on internal efficiencies and ensure that they create valuable products and services that consumers will continue to demand in myriad bruised and battered economies.

So allow me to (hopefully not too clumsily) segue to today's topic, Islamic finance. I’ll start by prefacing the fact that I am no expert on this topic, but I will make specific reference to those who are experts in Australia and I’ll touch on the relevance of some of the guiding principles in regard to what conventional finance might glean from this thought-provoking philosophy.

How Islamic finance challenges established paradigms

The reason why I began this piece by mentioning the divide between a) the very poor methods of global governments; and b) the free-market demands that require sustainable individual businesses to thrive, is because Islamic finance, or Islamic banking, very cleverly places a focus on the merits of a business by the way it handles inward investment.

Here is the guiding principle that I find most fascinating about Islamic finance: The prohibition of interest. At first, this concept seems bizarre. Imagine depositing your cash in the bank and earning nothing. But then consider what might happen if all of this lazy cash sitting in bank accounts suddenly had to find alternate ways of growing in line with the investors’ needs and liabilities, while at the same time beating inflation. Suddenly, cash would disappear from bank accounts and find its way into business.

On the basis that a significant percentage of retail investments sit in cash presently, if the banks stopped paying interest, the shift into the equity market--given the conventional bond market would be out of bounds due to its dependency on interest payments--would be seismic. For example, ‘invested’ cash sitting in Australian self-managed super funds alone comes in at 134 billion dollars, versus a 998 billion dollar market capitalisation of the ASX 50, where no doubt much of that cash would end up.

The demand for enterprise in the micro economy would be so great, the drive for entrepreneurialism may well create issues of its own, which is why I’ll refer back to the introduction and suggest that conventional finance might begin to ‘glean’ and incorporate practices of Islamic finance rather than push the unlikely concept that these principles might suddenly be adopted.

Why would I lend money to a business without earning interest?

In the absence of interest, one might ask how the investor gains a return on monies lent. This is where another guiding principle takes over: profit sharing.

There are many Islamic finance structures that avoid the requirement of interest payments, one of them being equity-based financing, where the financier either takes a passive or active interest in the asset being purchased. So rather than seeing institutions structure retail investment offers based on an interest rate above a benchmark rate, like the hybrid space for instance, that same institution might have to consider how much of its business it is willing to offer in exchange for cash, much like the process of a company listing its shares on an exchange.

Some might perceive this avoidance of interest and focus on profit and risk sharing as a huge plus, as it is a move away from the use of currency as a store of value. Given the influence of governments over the value of national currencies, investors are becoming more interested in the micro economy, where true value is gauged through the quality of enterprise. In a similar way that investors flocked to gold when US and European central banks increased the size of their balance sheets artificially, investors are flocking to the micro economy as a store of value that can be much more reliable than the practices of desperate governments and central banks.

Quick facts
  • While Islamic finance has a large audience (23% of the world’s population follows Islam), the funds that it attracts still have much room to grow. If the entire industry were a single entity, it would be the equivalent of the world’s 30th largest bank, according to Standard & Poors
  • As well as prohibiting interest, Islamic finance does not allow investment in intoxicating drinks, non-halal foods, arms, pornography or gambling
  • An Islamic finance investment must involve underlying assets, so investment into financial derivatives are not permitted
  • The guiding principle that avoids uncertainty and gambling means that speculative investments are largely excluded from Islamic finance
  • The leading non-Muslim financial centres establishing themselves as centres for Islamic finance are London, Hong Kong and Singapore
Resources

An excellent three-part piece from Australian law firm Corrs Chambers Westgarth:

  1. http://www.corrs.com.au/publications/corrs-in-depth/islamic-finance-in-australia-part-1-introducing-islamic-finance/
  2. http://www.corrs.com.au/thinking/insights/islamic-finance-in-australia-part-2-islamic-finance-opportunities-down-under/
  3. http://www.corrs.com.au/thinking/insights/islamic-finance-in-australia-part-3-whats-stopping-islamic-finance-flourishing-down-under-and-what-must-be-done/

Liquidity House Kuwait

  1. http://www.liquidityhouse.com/upload/AUK_presentation_(23-3-2010).pdf

Statistical, Economic and Social Research and Training Centre for Islamic Countries

  1. http://www.sesrtcic.org/files/article/450.pdf
comments powered by Disqus

DISCLAIMER: Rivkin aims to provide clear and simple information to those visiting our website. If any part of this disclaimer does not make sense, please phone Rivkin and ask to speak with a member of our Dealing and Relationship Management Team. Rivkin provides general advice, securities and derivatives dealing services and accounting administration services. Rivkin does not provide advice that takes into account your, or anybody else's, investment objectives, financial situation or needs. We strongly suggest that you consult an independent, licenced financial advisor before acting upon any information contained on this website. Investing in and trading securities (such as shares listed on the ASX) and/or derivatives (such as Contracts for Difference or 'CFDs') carry financial risks. CFDs carry with them various additional risks that differ from more simple securities such as fully-paid company shares. Some of these risks include not owning the underlying instrument from which a price is being derived, settling trades 'over the counter' with a financial institution rather than on a stock exchange, and using leverage to gain access to trades that may have a higher face value than your initial deposit. This risk of leverage means that it is possible to lose more than your initial investment. Our aim is to create more life choices for our clients, which means improving the wealth of clients throughout many market cycles by nurturing a relationship spanning many years. If you are not comfortable with your understanding of the risks involved before using a Rivkin product and service, please contact our office to seek further information or a Product Disclosure Statement, or make an appointment to sit with one of our friendly financial experts. It is in our interest for your Rivkin experience to be a rewarding and comfortable one. Rivkin is a trading name of Rivkin Securities ABN 87123290602, which holds Australian Financial Services Licence No. 332 802.