Consider the Islamic option

The financial crisis has shown us the downside of many conventional financial instruments, but Islamic banking products are believed to have emerged relatively unscathed and investors in these products are believed to have done better than those investing in more traditional products.

Experts say the prohibition on charging interest and the lack of structured Islamic banking products may have prevented the sector from investing in assets that turned fatal for conventional banks.

Moinuddin Malim, Head of Corporate and Investment Banking in Badr Al-Islami Bank, says: "Islamic finance and investment is about value creation. An asset always backs the underlying product in addition to the track record of the investment manager, the true valuation of the asset and its performance.

"Investors' interests are safeguarded by the fund manager or trustee, known as the Mudarib. And while the Mudarib may not avoid market risk, it is his responsibility to develop the investor funds into selected asset category."

No Islamic financial institution has acknowledged investing in Bernard Madoff's $50 billion (Dh183bn) Ponzi scheme, and Saleh Al Tayar, Secretary General of the Franco-Arab Chamber of Commerce, says the $4.9bn hit taken by Societe Generale as a result of Jerome Kerviel's actions couldn't have happened in an Islamic institution.

"If global banking practices were based on Islamic practices then we wouldn't be seeing this kind of crisis," he says.

Islamic financial institutions work on a philosophy of prohibiting transactions considered immoral and promoting greater social justice by sharing risk and reward. Investing in casinos, pornography, arms or anything to do with pork is out: Long-term investments in projects beneficial to society are in.

Interest payments, short selling and contracts considered excessively risky are also prohibited. That rules out products that got Western finance into trouble, such as subprime mortgages, collateralised debt obligations or credit default swaps.

Fewer retail options 

However, mass retail products available for Islamic customers are very limited in the UAE market. UAE bank assets that comply with Islamic law now account for less than 20 per cent of total bank assets, according to Tirad Mahmoud, Chief Executive of the Abu Dhabi Islamic Bank.

More often than not, Islamic retail customers are forced to keep their funds in current, savings or Mudaraba Time Deposits, which yield returns based on how well the underlying institution has performed. Investors in the UAE can invest Dh100 or multiples thereof in the National Bonds scheme, which work on Mudaraba concept as well and has a gift scheme through which investors can win up to Dh1 million in prize money.

At the premium retail level where investors have the appetite to opt for savings around Dh100,000 or more, there are several options, most based on mutual fund structures with various flavours and targeting various geographic territories and market segments from local, regional to international.

"Islamic banking and finance has not reached the sophistication attained by conventional banking to provide complex and highly complicated investment product structures," says Malim. "However, every Islamic banking product, its structure, implementation and documentation is vetted by Shariah scholars who are guided by international law firms and industry experts. This is one reason why such products have a better chance of attaining investors' interest in today's challenging times."

Muneer Khan, a partner in a law firm Simmons & Simmons, has invested in Mudarabah term deposit, saying: "I have received a profit rate broadly equivalent to the prevailing interest rate for conventional savings accounts.

"I am happy to invest in such products as statistics show Islamic equities funds tracking Islamic indices ( provided by FTSE and Dow Jones) have performed better during the financial crisis than conventional index trackers, as the Islamic indices do not include conventional financial institutions."

Growth ahead 

And the Islamic finance sector is growing, even as the global financial industry shrinks. In 2008 alone, Noor Islamic Bank and Ajman Bank started operations. Abu Dhabi Islamic Bank plans to open six new branches in the UAE before April and is actively seeking acquisitions and branch expansion in Middle East countries.

Says Mahmoud: "The bank's liquidity position is strong and we have not slowed lending; but we will be prudent and selective. The market is tougher, but opportunities are there and we will capitalise on those. In the UAE, Islamic banking's share [of the pie] is growing and it will surpass 50 per cent in 10 years."

Risk factors 

However, a recent Moody's report says Islamic financial institutions are not immune to risk as there is a shortage of liquid instruments and the lack of an Islamic inter-bank market. The agency expects growth in Islamic banking assets to slow in 2009, to 10 to 15 per cent compared to 20 to 30 per cent this year.

Islamic banks now stand in the same firing line as non-Islamic counterparts, facing a slump in equities valuations and slowed growth in regional real estate, to which they are heavily exposed.

Even though Islamic banks avoided the speculative investments and complex financial instruments that derailed Western banks, their balance sheets still show a mismatch between assets and liabilities, and they depend more on short-term maturity liabilities than conventional banks.

The sukuk market faced many challenges last year – the global credit crisis, rising borrowing costs, lack of investor commitment to capital market securities and debates over the Shariah compliance of some sukuk structures.

"By the end of 2008, global sukuk issuance had declined by more than 50 per cent," says Moody's Faisal Hijazi.

But experts say products like sukuks do not reflect the value of the underlying assets and only show the supply and demand situation.

"Investors holding these assets till maturity have better prospects of getting the face value back rather than taking a trading loss on mark to market loss for such instrument. This needs to be qualified on the ability of the underlying issuer to be able to refinance the assets at maturity or pay back the investment to the investors," says Badr Al-Islami's Malim.

Term paper

Islamic Finance refers to a system based on the principles of Islamic or Shariah law. Shariah prohibits the payment of fees for the renting of money (Riba) for specific terms, as well as investing in businesses that provide goods or services considered contrary to its principles – or Haraam. The principle of Islamic banking is sharing profit and loss and the prohibition of Riba.

Murabaha

An Islamic mortgage transaction where instead of giving a loan to the buyer to purchase the item, a bank buys the item from the seller, and re-sells it to the buyer at a profit, while allowing the buyer to pay the bank in installments. From the start the item is registered in the name of the buyer.

Sukuk

Equivalent to a bond, these securities comply with Islamic laws on interest and are not fixed-income or interest-bearing.

Takaful

Islamic insurance against losses. The idea is, what is uncertain for an individual may cease to be uncertain to a large number of similar individuals. This is insurance by combining the risks of many, thus enabling each individual to enjoy the advantage provided.

Musharaka Al Tanaqisa 

A home loan that allows for a floating rate in the form of rent. The bank and borrower form a partnership, providing capital at an agreed percentage to purchase the property. The partnership entity rents out the property to the borrower, who buys the bank's share on the property at agreed installments until the full equity is transferred to the borrower.

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