Islamic Finance: Overview and Policy Concerns

Islamic Finance: Overview and Policy
Concerns
Shayerah Ilias
Analyst in International Trade and Finance
Foreign Affairs, Defense, and Trade Division
Summary
Islamic finance is based on principles of shariah, or “Islamic law.” Major
principles of shariah are a ban on interest, a ban on uncertainty, adherence to risk-
sharing and profit-sharing, promotion of ethical investments that enhance society, and
asset-backing. The international market for Islamic finance has grown between 10% to
15% annually in recent years. Islamic finance historically has been concentrated in the
Persian Gulf countries, but has expanded globally to both Muslim and non-Muslim
countries. There is a small but growing market for Islamic finance in the United States.
Through international and domestic regulatory bodies, there has been effort to
standardize regulations in Islamic finance across different countries and financial
institutions, although challenges remain. Critics of Islamic finance express concerns
about possible ties between Islamic finance and political agendas or terrorist financing
and the use of Islamic finance to circumvent U.S. economic sanctions. Proponents argue
that Islamic finance presents significant new business opportunities and provides
alternate methods for capital formation and economic development.
Background
Islamic finance is based on shariah, an Arabic term that is often translated into
“Islamic law.” Shariah provides guidelines for aspects of Muslim life, including religion,
politics, economics, banking, business, and law.¹ Shariah-compliant financing (SCF)
constitutes financial practices that conform to Islamic law. Major principles of shariah
that are applicable to finance and that differ from conventional finance are:
^!Ban on interest (riba): In conventional forms of finance, a distinction is
made between acceptable interest and usurious interest. In contrast,
under Islamic law, any level of interest is considered to be usurious and
is prohibited.

¹ Michael Silva, “ Islamic Banking Remarks,” Law and Business Review of the Americas, Spring

2006, 12, 2.

^!Ban on uncertainty: Uncertainty in contractual terms and conditions is
not allowed, unless all of the terms and conditions of the risk are clearly
understood by all parties to a financial transaction.
^!Risk-sharing and profit-sharing: Parties involved in a financial
transaction must share both the associated risks and profits.
^!Ethical investments that enhance society: Investment in industries that
are prohibited by the Qur’an, such as alcohol, pornography, gambling,
and pork-based products, are discouraged.
^!Asset-backing: Each financial transaction must be tied to a “tangible,
identifiable underlying asset.” Under shariah, money is not considered
an asset class because it is not tangible and thus, may not earn a return.²
Some question how lenders profit from financial transactions under Islamic law. For
instance, in a real estate setting, SCF takes the form of leasing, as opposed to loans.
Instead of borrowing money, the bank obtains the property and leases it to the shariah-
compliant investor, who pays rent instead of interest. Earnings of profits or returns from
assets are permitted so long as the business risks are shared by the lender and borrower.³
International Scope of Islamic Finance
Modern Islamic finance has existed internationally since the 1970s. Currently, Islamic
finance represents a small but growing segment of the global finance industry. Estimates
vary of the total size of assets held internationally under Islamic finance, ranging upwards
from $800 billion and with growth rates of 10% to 15% annually over the past ten years.⁴
The global market for Islamic bonds, known as sukuk,⁵ is estimated to be $70 billion
currently and is projected to reach $100 billion by 2010.⁶ Global issuance of sukuk has
increased more than five-fold from 2004 to 2007 (see Figure 1).⁷
In some countries, such as Iran and Pakistan, Islamic banks are the only mainstream⁸
financial institutions. In others, SCF exists alongside conventional banking. The Persian
Gulf region and Southeast Asia, led by Malaysia, historically have been the major centers
for SCF. For oil producers in the Gulf region, Islamic finance may offer investment
opportunities for their growing revenues from oil exports. There also has been a growing

² The National Bureau of Asian Research, “Islamic Finance: Global Trends and Challenges,”
Volume 18, Number 4, March 2008. Standard & Poor’s, “Islamic Finance Outlook 2008.”
³ Andreas Jobst, “The Economics of Islamic Finance and Securitization,” International Monetary
Fund (IMF) Working Paper WP/07/117, August 2007.
⁴ David Oakley, Shannon Bond, Cynthia O’Murchu, and Celve Jones, “Islamic Finance
Explained,” Financial Times, May 30, 2008.
⁵ Islamic bonds are constructed as profit-sharing or rental agreements that are tied to physical
assets.
⁶ Standard & Poor’s, “Islamic Finance Outlook 2008.”
⁷ Andreas Jobst, Peter Kunzel, Paul Mills, and Amadou Sy, “Islamic Bond Issuance - What
Sovereign Debt Managers Need to Know,” IMF Discussion Paper, PDP/08/3, July 2008.
⁸ Shirley Chiu, Robin Newberger, and Anna Paulson, “Islamic Finance in the United States,”
Society, September/October 2005.

awareness of and demand for Islamic finance options by Muslim consumers. In recent
years, SCF has expanded into Africa, particularly Sudan.⁹
Figure 1. Global Issuance of Islamic Bonds, 2004-2007

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Support for Islamic finance varies in the Middle East. In some countries, such as
Libya and Morocco, Islamic banks are considered by some to be tied to Islamic political
parties and consequently have been refused licenses. Other countries, including Jordan,
Tunisia, and the Sudan, have been receptive to Islamic finance, viewing Islamic financial
products as an opportunity for creating capital and fostering economic development.¹⁰
Islamic finance is growing in Europe and North America, areas in which Muslims are
in the minority. In August 2004, the United Kingdom’s Financial Services Authority
(FSA) approved a banking license for the Islamic Bank of Britain (IBB), the country’s first
Islamic bank. The IBB would serve the consumer market with shariah-compliant
products.¹¹ In March 2006, the FSA licensed the European Islamic Investment Bank as
the United Kingdom’s first independent bank for shariah-compliant investments.
Islamic Finance in the United States
With an estimated five to seven million Muslims in the United States, there is
growing interest for Islamic finance and business opportunities for lenders. Some have
suggested Islamic finance may be an attractive option for investors as conventional finance¹²
faces challenges from the U.S. subprime lending crisis and recession concerns. In the
United States, SCF largely exists in personal home mortgages. Guidance Residential
(Reston, Virginia) reportedly has financed over 5,000 shariah-compliant mortgages since
⁹ Vikram Modi, “Writing the Rules: The Need for Standardized Regulation of Islamic Finance,”
Harvard International Review, Spring 2007.
¹⁰ Ibid.
¹¹ Standard & Poor’s, “Islamic Finance Outlook 2008.”
¹² Peter Apps, “Global financial centers battle for Islamic markets,” International Herald
Tribune, July 25, 2008.

2002.¹³ Other financial intermediaries that provide Islamic-based home mortgages include
University Islamic Financial (Ann Arbor, Michigan), Devon Bank (Chicago, Illinois), and
American Finance House Lariba (Pasadena, California). HSBC is the only large
commercial bank that offers U.S. Islamic finance and is focused on New York. ¹⁴ The
Federal National Mortgage Association (Fannie Mae) and the Federal Home Mortgage
Corporation (Freddie Mac) purchase shariah-compliant mortgage contracts from financial
intermediaries, allowing providers to originate further mortgages. In 2007, Freddie Mac
reportedly purchased more than $250 million in Islamic home loans, a small but notable
fraction of the enterprise’s $1.77 trillion in business activities.¹⁵
Other forms of shariah-compliant services are offered in the United States as well.
For instance, Devon Bank and Zayan Finance offer SCF for commercial real estate.
Shariah-compliant mutual funds are offered by intermediaries such as the Amana Mutual
Funds Trust, Azzad Funds, and the Dow Jones Islamic Fund.¹⁶ In 1999, the Dow Jones
presented its first Islamic market index, which follows shariah-compliant stocks
internationally. The Dow Jones maintains more than 70 indices in its Islamic series and
is advised by an independent Shariah Supervisory Board counsel.¹⁷
International financial intermediaries also provide SCF in the United States. Islamic
investors from the countries of the Gulf Cooperation Council (GCC) have sought to
diversify their financial portfolios geographically and to invest their oil wealth in U.S.
assets. For instance, the Bahrain-based Arcapita Bank has structured many shariah-
compliant transactions in private equity and real estate in the United States.¹⁸ Additionally,
U.S.-based companies have taken advantage of alternative funding sources through
Islamic-financing abroad. According to Standard & Poor’s, Loehmann’s Holdings, Inc.
and East Cameron Gas Company have issued rated shariah-compliant bonds.¹⁹
Islamic Finance Regulation
Financial institutions seeking to offer shariah-compliant products typically have a
shariah supervisory board (or at a minimum, a shariah counselor). The shariah board
would review and approve financial practices and activities for compliance with Islamic

¹³ N.C. Aizenman, “A Higher Law for Lending,” The Washington Post, May 13, 2008.
¹⁴ Shirley Chiu, Robin Newberger, and Anna Paulson, “Islamic Finance in the United States,”
Society, September/October 2005.
¹⁵ N.C. Aizenman, “A Higher Law for Lending,” The Washington Post, May 13, 2008.
¹⁶ “Islamic Finance Gaining Traction in the U.S.,” Dinar Standard, November 22, 2007.
¹⁷ Dow Jones, “Dow Jones Islamic Market Index: World Measures With a New Perspective,” data
current as of March 31, 2008.
¹⁸ “Ali: Islamic Banking is a Rapidly Growing Industry,” Council of Foreign Relations interview,
June 8, 2007.
¹⁹ Standard & Poor’s, “The Islamic Financial Industry Comes of Age,” Commentary Report,
October 25, 2006.

principles. Such expertise raises the attractiveness of shariah-compliant financial
intermediaries to investors considering SCF.²⁰
Shariah is open to interpretation and Islamic scholars are not in complete accordance
regarding what constitutes SCF. Islamic finance laws and regulatory practices vary across
countries. The lack of concurrent viewpoints makes it difficult to standardize Islamic
financing.²¹ Many observers view standardization of SCF regulations as important in
increasing the marketablity and acceptance of Islamic products.
International institutions have been established to promote international consistency
in Islamic finance. For instance, the Islamic Financial Services Boards (IFSB) puts forth
standards for supervision and regulation.²² As another example, the Accounting and
Auditing Organization for Islamic Financial Institutions (AAOIFI), issues international
standards on accounting, auditing, and corporate governance.²³ Many leading Islamic
financial centers around the world have adopted international SCF regulation standards.²⁴
U.S. federal banking regulators have provided some formal guidance about Islamic
products. The Office of the Comptroller of the Currency (OCC) issued two directives
concerning shariah-compliant mortgage products. In 1997, the OCC issued guidance
about ijara (“lease”), a financial structure in which the financial intermediary purchases
and subsequently leases an asset to a consumer for a fee. In 1999, the OCC recognized
murabaha (“cost-plus”), under which the financial intermediary buys an asset for a
customer with the understanding that the customer will buy the asset back for a higher fee.
U.S. Policy Concern and Issues for Congressional Interest
As Islamic finance activities grow in the United States, critics raise concerns about
the related capital adequacy and system risks. Proponents of Islamic finance assert that
the ban on risk-taking mitigates many concerns. Some also view the integration of ethics
and values into finance as a positive development, especially in light of recent U.S.
business corruption scandals. Many investors reportedly consider SCF to be more reliable
than conventional financing, given the recent global credit crisis and fears of economic
recession.²⁵ Some observers suggest that full disclosure of SCF-related risks may alleviate
investor concerns and increase accessibility to Islamic financial products.²⁶

²⁰ Juan Solé, “Introducing Islamic Banks into Conventional Banking Systems,” IMF working
Paper WP/07/175, July 2007.
²¹ “Islamic Banks: A Novelty No Longer,” BusinessWeek, August 8, 2005.
²² Ibid. Information about standards issued by the IFSB are available at [http://ifsb.org].
²³ AAOIFI standards are available on AAOIFI’s website, [http://www.aaoifi.com/].
²⁴ “Watchdog is developing governance standards,” Misr Information Services and Trading News,
July 28, 2008.
²⁵ Peter Apps, “Global financial centers battle for Islamic markets,” International Herald
Tribune, July 25, 2008.
²⁶ Vikram Modi, “Writing the Rules: The Need for Standardized Regulation of Islamic Finance,”
Harvard International Review, Spring 2007.

The growth of Islamic finance in the United States may have implications for
congressional oversight. Congress may be interested in evaluating the relationship between
the current U.S. banking legal and regulatory framework and Islamic finance. Current
U.S. laws and regulation may be broad enough to accommodate some aspects of Islamic
finance. Others aspects of Islamic finance may pose some unique challenges to U.S. laws
and regulations, such as applying rules created for conventional, interest-based products
to Islamic products.²⁷ There is debate about whether or not, or the extent to which,
regulators should apply rules on conventional products to Islamic product counterparts.²⁸
Some express concerns about the national security implications of Islamic finance,
specifically that Islamic banking transactions may channel funds to terrorists or “facilitate
terrorists’ access to funds.” Others assert that the risks of Islamic finance are not
significantly greater or different than those from conventional finance and that the majority
of recent terrorist financing cases related to SCF have been thrown out of court. In
congressional testimony, one observer stated “there is no reason - in theory - to suspect
that Islamic finance would be particularly immune or particularly vulnerable to abuse by
money launderers or terrorist financiers.”²⁹ Some proponents also assert that security-
related concerns about Islamic finance stem from a lack of understanding of SCF or from
stereotyping.³⁰ There may be a “conflation” of Islamic finance with hawala, an informal
trust-based money transfer system prominent in the Middle East and many Muslim
countries. Hawala transactions are based on an honor system, with no promissory
instruments exchanged between the parties and no records of the transactions. Some
analysts consider the hawala system particularly susceptible to terrorist financing.
Congress also may be interested in the possibility of Islamic finance as a vehicle for
sidestepping U.S. and international economic sanctions. For example, the Sudanese
government reportedly issued Islamic bonds to Gulf investors in order to circumvent U.S.
sanctions.³¹

²⁷ Thomas C. Baxter, “Regulation of Islamic Financial Services in the United States,” Remarks
Before the Seminar on Legal Issues in Islamic Financial Services Industry, March 2, 2005.
²⁸ Vikram Modi, “Writing the Rules: The Need for Standardized Regulation of Islamic Finance,”
Harvard International Review, Spring 2007.
²⁹ Mahmoud A. El-Gamal, “Islamic Finance in the Middle East,” testimony prepared for U.S.
Senate Committee on Banking, Housing and Urban Affairs, “Money Laundering and Terror
Financing Issues in the Middle East” hearing.
³⁰ Michael Silva, “ Islamic Banking Remarks,” Law and Business Review of the Americas, Spring

2006, 12, 2.

³¹ “Turning towards Mecca: Islamic banks join in the race of Africa,” Economist, Vol. 387, Issue

8579, May 10, 2008.