For millions of people from Morocco to Malaysia, banks are institutions to be avoided.
Some of these people, of course, are simple farmers who - like their counterparts in rural areas all over the world - are wary of any organization not rooted in their own village. But many are sophisticated professional and business people, versed in the world's ways, and it is not suspicion but religion that keeps them from the teller's window: Their Islamic beliefs bar them from dealings they define as usurious and, thus, prohibited.
Yet Muslims need banking services as much as anyone and for the same multiplicity of purposes: to finance new business ventures, provide crop loans, facilitate capital investment, and offer a safe place for savings. Nor are Muslims averse to legitimate profit: The Prophet Muhammad himself was a successful businessman in a part of the world where international trade was the daily bread of whole tribes and clans.
But today's financial world moves much faster than that of the sixth century. It is far more tightly knit, and it inextricably links Muslim and non-Muslim nations - and individuals. In that world, can Muslims still find room for the principles of their religion? The answer comes with the rise, largely during the last decade, of international Islamic banking.
For the first time since the principles of Islamic finance were laid down in the Koran 14 centuries ago, a global network of Islamic banks, investment houses and other financial institutions has started to take shape. The experience of the past 10 years has indicated that the demand for Islamic banking is strong, but that the institutions themselves, and international cooperation among them, must be strengthened if the young system is to reach its full potential.
During the era of the Prophet Muhammad and the subsequent half millennium of flourishing Islamic civilizations, banking as we know it did not exist. People who accumulated some excess money kept it at home in the form of coins, or commodities such as grain, and regional or international trade was usually conducted among a small group of merchants who financed themselves and often dealt by barter.
Today's brand of financial intermediation, with banks dealing in money itself as a commodity to be bought, sold, borrowed, lent, stored and priced according to market or monopolistic forces, stems from the development of merchant banks in Holland and Italy in the Middle Ages. From them, banks have developed that today offer wide-scale retail and corporate banking services, finance international trade, and manage the capital markets of the globe, catering to the changing needs of industrialists, farmers, entrepreneurs and even entire countries.
Small-scale rural or neighborhood-level experiments in Islamic banking were attempted in Pakistan in the 1950's and in Egypt in the early 1960's and 1970's. It was the oil-fueled boom of the mid-seventies, however, that caused many Muslims to explore how Islamic financial practices could be applied to large-scale retail and commercial banking.
Modern Islamic banking grew rapidly from three roots. As oil prices increased after 1974, a number of Arab and Muslim countries experienced a rise in national income, in economic activity within and across their borders, and in the cash balances available for investment. Simultaneously, they became dissatisfied with the rigid requirements of commercial banks - most of them Western ones - and the banks' view of interest-earning activities as their central reason for being. And finally, in countries stressed and challenged by rapid industrialization and urbanization and by greatly increased commercial activity, the belief grew that the best response, for both individuals and communities, might be a reinvigoration of the principles of Islam - principles that had sustained and defined those communities for 1,400 years.
The Koran is clear about the prohibition of riba, which is sometimes defined as excessive interest. However, Muslim scholars have accepted the word to mean any fixed or guaranteed interest payment on cash advances or on deposits. Several Koranic passages expressly admonish the faithful to shun interest:
"Ye who believe! Fear God and give up what remains of your demand for usury, if ye are indeed believers."
The prohibition on paying or receiving fixed interest is based on the Islamic tenet that money is only a medium of exchange, a way of defining the value of a thing; it has no value in itself, and therefore should not be allowed to give rise to more money, via fixed interest payments, simply by being put in a bank or lent to someone else. The human effort, initiative, and risk involved in a productive venture are more important than the money used to finance it.
As defined in the Shari'a, or Islamic law, Islamic economics is based on the belief that the provider of capital and the user of capital should equally share the risk of new business ventures, whether those are industries, farms, service companies or simple trade deals. Translated into banking terms, the depositor, the bank and the borrower should all share the risks and the rewards of financing business ventures. This is unlike the interest-based commercial banking system, where all the pressure is on the borrower: He must pay back his loan, with the agreed interest, regardless of the success or failure of his venture.
A final feature of Islamic economics is the requirement that investments support only practices or products that are not forbidden - or even discouraged - by Islam. Trade in alcohol or arms, for example, would not be financed by an Islamic bank; a real-estate loan could not be made for the construction of a gambling casino; and the bank could not lend money to other banks at interest. Except for the ban on interest, these restrictions are similar to limitations on the few investment funds in the United States and Britain that exclude what their customers consider morally questionable industries: Some examine their investments on environmental grounds, some refuse to invest in defense industries or companies dealing with South Africa, others bar investments in tobacco companies, for example.
Islamic banks around the world have devised many creative, flexible variations on the risk-sharing, profit-sharing principles of Islamic banking (see box). A group of people in Jerash, Jordan, for example, had the land for the community college they wanted to build, but not the money for construction. An Islamic bank built and furnished the college and agreed to be repaid with a 30-percent slice of students' tuition fees. But after the school opened, the government raised admission standards; the number of students - and the college's cash flow - fell to half of predicted levels. The Islamic bank responded by stretching out the repayment period.
Another Islamic bank finances individuals' car or taxi purchases by murabaha, buying the vehicle and then transferring ownership to the client, who repays the cost over 36 to 40 months. If the client cannot repay on the original schedule nor on a revised one, the bank agrees with him to sell the car in the second-hand market for whatever it will bring - whether or not the proceeds cover the outstanding balance of the original debts.
Besides their range of equity, trade-financing and lending operations, Islamic banks also offer a full spectrum of fee-paid retail services that do not involve interest payments, including checking accounts, spot foreign exchange transactions, fund transfers, letters of credit, travelers' checks, safe-deposit boxes, securities safekeeping investment management and advice, and other normal services of modern banking.
The public's acceptance of Islamic banking has been quicker and much greater than any of its pioneering advocates had anticipated, with more than $10 billion dollars now thought to be deposited in Islamic banks. The banks initially attracted depositors whose religious beliefs had always caused them to shun commercial banks' interest-bearing savings accounts. Then, once they had proved their viability and safety, the Islamic banks attracted other clients who preferred the less pressured style of profit-sharing dealings, or who shared the social and moral precepts of Islamic banking, particularly the belief that wealth should be directly invested in socially and economically productive ventures rather than idly earning money in interest-bearing accounts.
The first of the contemporary Islamic banks, the Dubai Islamic Bank, was founded in 1975. Between that year and 1983, most new Islamic banks were established in Arab countries, such as Bahrain, the United Arab Emirates, Sudan, Egypt, Saudi Arabia, Jordan, Kuwait and Qatar. In the past four years, though, Islamic banking has spread more widely throughout Muslim and non-Muslim countries, with new banks opening their doors in Turkey, Malaysia, Bangladesh, Tunisia, Denmark, Great Britain, Guinea, Senegal, Switzerland, Luxembourg and India, among others. Today, there are more than 100 Islamic banks and financial institutions throughout the world, and several multinational banking companies, such as Al Baraka and Dar al Maal al Islami, spearhead the establishment of new institutions and the development of innovative Islamic financial instruments.
Only Iran and Pakistan have legally required their entire banking systems to apply Islamic financial practices. In other countries, Islamic and interest-based commercial banks operate side by side; increasingly, they cooperate with one another on principles acceptable to both.
Western observers insist on assessing Islamic banks primarily by comparing their financial returns with those of interest-based banks. And in most cases, the Islamic banks have paid dividends to their shareholders and profits to their depositors that compare well with the rates of interest-paying commercial banks. But even so, Islamic bankers shun this comparison, insisting that their depositors and clients consider both financial criteria and the satisfaction of conducting their business in accord with the dictates of their religion and their ethical traditions. Indeed, some Islamic banking activities are not designed to make a profit, such as qard hassan, or social-purpose loans, extended to poor or needy individuals at no charge. With nearly a decade of experience behind them, several of the larger Islamic banks and investment companies have gathered valuable practical data about the actual demand in the marketplace for Islamic banking services - and about the constraints that result from the lack of a formal global Islamic banking network. Now, they're putting the data to work.
Seven years after it opened its doors, the Jordan Islamic Bank for Finance and Investment (JIB) has become the fourth largest of Jordan's 22 banks and investment companies, with total deposits of over $350 million. From 6,000 clients at the end of its first year of business, it has grown to more than 65,000.
JIB General Manager Musa Shihadeh notes that the growth has come despite the fact that clients' net year-end returns have averaged two to three percentage points less than what they would have earned in an interest-bearing commercial bank account. Their gross average return on deposits has ranged from 5.4 percent to 8.2 percent since 1980, while net earnings on deposits varied from 2.74 percent on savings accounts to 4.93 percent on fixed-term accounts.
"Our clients are not motivated solely by financial gain," Shihadeh said in a recent interview in Amman. "Their two main criteria are to honor their deeply-held religious beliefs, and to deal with banks that offer confidence and minimum risk."
By mid-1986, JIB had invested $239 million in mudaraba, murabaha and equity-participation investments. Another $37 million is in "specific investments" - projects which the bank initiates and manages with investors' funds earmarked specifically for those projects. The biggest specific investment to date has been the $42-million Rawdah middle-income housing complex in a north Amman residential area, comprising 30 houses, 213 duplex apartments, a commercial center, public plazas, a school and parking areas. Upon completion this year, the housing units will be sold to the public, and the profits will be shared between the investors, who financed 60 percent of the project, and the bank, which also takes a small management fee.
Other similar projects for low- and middle-income groups will be launched in the near future. This year, for example, the bank will begin to offer loans of up to $30,000 to craftsmen - carpenters, painters, iron workers and the like - who want to start or expand their businesses. The service will be based on the decreasing-participation principle, by which the bank takes a smaller share of the craftsman's annual profit each year until the loan is fully repaid and JIB has earned a profit of its own.
Such projects should help to absorb some of the bank's unusually high cash liquidity, which ranges between 40 and 45 percent. High percentages of uninvested cash are a problem shared by many Islamic banks during the current recession, when good, permissible investment opportunities are hard to find.
Another fast-growing Islamic bank is the Kuwait Finance House (KFH), established in 1978. Its balance sheet totaled $2.74 billion at the end of 1985, with deposits of $2.39 billion. At one point in 1984, when it was taking in money faster than it could find profitable investment outlets, it stopped accepting some types of deposits for more than a year.
Nonetheless, KFH registered a net profit of $57.7 million in 1985, made a 10-percent bonus stock offer to shareholders, and paid up to four percent on time deposits. With 13 branches throughout Kuwait - including the country's first drive-in teller - and two more planned, Kuwait Finance House has one of the largest domestic branch networks of any Islamic bank. It is also one of the most consumer- and retail-oriented: Its trading division offers consumer financing for cars, furniture or construction materials, and even food and clothing.
One of its most successful services has been to put together real-estate portfolios which are financed directly by customers who buy "certificates" - effectively shares - in the portfolios. Because most of the rental income from the properties in the portfolios can be gauged in advance, these investments offer clients an "expected return" of between 6.5 and 8 percent - one of the few instances where Islamic banks can anticipate, though not guarantee, the return on an investment.
The three real-estate portfolios offered to date, worth a total of $92.5 million, have been fully subscribed. In an interview, KFH General Manager Adnan Bahr said that he is talking with the Kuwaiti Commerce Ministry about listing the real-estate portfolio certificates on the Kuwait Stock Exchange later this year, where they could be bought and sold on the open market.
"We're a retail bank," says Bahr, who joined KFH as a local credit officer in 1981. "Our aim is to develop a full range of retail and commercial banking services in a manner that conforms to the Shari'a. We need time to identify what the market needs, and then to develop new investment and financing instruments that conform to Islamic principles."
KFH is looking into the possibility of issuing five-year negotiable certificates of deposit (CDs), which would be listed on local stock exchanges throughout the Arabian Gulf countries. The deposits themselves would be used either for specific projects or for the bank's general investments. Buyers of the CDs would not be guaranteed a fixed return, but they would share in the profits of projects financed by their money. KFH would always quote prices for the five-year CDs, thereby creating a secondary market in Islamic CDs that does not now exist.
KFH's latest innovation is to sell apartments, homes and building lots to buyers who qualify for a 10-year mortgage arranged jointly with a local savings and loan. Another new service to be offered this year will be automated teller machines, already widely used by commercial banks throughout the Middle East.
"We want to be innovative," says Dr. Khalid M. Boodai, KFH's Assistant General Manager for Finance. The former University of Kuwait professor, educated at Michigan State and the University of Missouri, joined the bank in 1982. "We want to identify services which will appeal to a wide client base."
One of the biggest and most successful Islamic banks is the eight-year-old Faisal Islamic Bank of Egypt, which now boasts total assets of more than $2.27 billion. Most of the bank's 1,200,000 customers are small savers with a few hundred or thousand dollars that they had previously kept at home. The bank has attracted over $1.75 billion in deposits to date, and has some $1.7 billion in outstanding investments, including equity participations in small-scale industries, larger manufacturing and agro-industrial companies, and tourist and trade ventures. In recent years it has recorded a 16.52-percent return on capital, and has paid a nine-percent annual return on deposits in investment accounts.
A smaller but equally profitable operation is the Qatar Islamic Bank, founded in 1983, which made a profit of $2.3 million in 1985-86 and paid an eight-percent dividend, down slightly from the previous year's 10-percent payout. Total assets increased by 46 percent during the year, to reach $242 million. In recent years, depositors have earned profits ranging up to 6.2 percent on savings accounts and eight percent on investment deposits of a year or longer.
Another of the successful smaller banks is the Bahrain Islamic Bank (BIB), established in 1979 and now boasting a total balance sheet of over $165 million, with deposits of more than $130 million. It has been consistently profitable since it was founded, and has registered net profits of over $7 million a year for the past two years.
"Islamic banking is no longer a novel experiment," BIB General Manager Abdul Latif Abdul Rahim Janahi said. "Islamic banks are going concerns, and we feel the rest of the banking world can now judge us on the basis of our performance, rather than on untested expectations."
One of the biggest and most dynamic Islamic banking conglomerates is the Al Baraka group, dominated by the prominent Saudi Arabian businessman Saleh Abdullah Kamel. The group includes banks, investment companies, financial advisory and management companies, and affiliated institutions in Bahrain, Sudan, Great Britain, Saudia Arabia, Turkey, Jordan, Tunisia, Luxembourg, Denmark, Thailand, Malaysia, and Mauritania. Though it started operations only in 1982, the Al Baraka Group now boasts a total balance sheet over $1.5 billion, and symbolizes the wide geographic scope open to Islamic banks.
A pioneer of modern Islamic banking, former Jordan Islamic Bank General Manager Dr. Sami Hassan Homoud, is now general manager of the Bahrain-based Al Baraka Islamic Investment Bank. That institution started operations in 1984 with the specific aim of creating a secondary market in Islamic financial instruments, to meet the need for more flexible investment instruments and broader investment opportunities.
An initial rush of deposits from Saudi Arabia and the Gulf states - 60 percent of which, Dr. Homoud says, came from people who did not use the banking system at all before - has seen the bank's balance sheet grow to more than $300 million in just three years. By the end of 1985, investments totalled $252 million, mostly in trade financing and equity participations spanning the globe. Year-end profits were distributed to depositors at the rate of 8.44 percent on joint investments.
The bank established a wholly-owned trading company in Malaysia to export Malaysian products to the Middle East, and thereby contribute to the bank's goal of promoting inter-Islamic trade. It also took part with other Al Baraka Group members in establishing the $100-million Arab Agricultural Company in Bahrain.
Homoud's immediate concern is to develop and launch new kinds of securities that would, like Kuwait Finance House's five-year certificates of deposit, promote the growth of a secondary market where investors could sell securities to raise immediate cash, or buy securities to invest excess cash.
"The Islamic banks attracted substantial deposits when they opened their doors," Homoud said in an interview in Bahrain recently, "but they soon ran into the twin constraints of the regional economic recession and the limited number of investment outlets that conformed to Shari'a principles. Unlike existing commercial banks, we cannot make use of Treasury bills, CDs, central bank rediscount facilities or the interbank markets, all of which are based on the principle of fixed interest payments. We aim to develop liquid financial instruments associated with a secondary or interbank market, which Islamic banks could buy in times of excess liquidity, or sell when liquidity is squeezed."
An immediate project is to launch a subsidiary investment company - named Al Tewfic Company for Investment Funds - with an initial capital of $20 million. The novel company will have two kinds of shares: $10 million in management shares with voting authority, to be owned 99 percent by Al Baraka, and $10 million in non-voting shares to be sold to the public. The company will undertake murabaha trade financing, leasing, and medium and long-term equity investments, with shareholders sharing in the annual profits. As it backs new projects it will issue new shares, to reach a maximum capital of $200 million. Al Baraka Islamic Investment Bank will buy back non-voting shares at any time, thus creating the permanent secondary market essential in any capital-market structure. The Bahrain Monetary Authority - the central bank of the island state - has already approved the idea of a company with a changing capitalization and with non-voting shareholders, and Homoud hopes to launch the venture around mid-year. The non-voting shares of Al Tewfic Company are priced at $100, to be attractive to individuals as well as institutions.
The other big Islamic banking conglomerate, with institutions and branches around the world is the Geneva-based Dar al Maal al Islami (DMI). It was founded in 1981 by Saudi Arabia's Prince Muham-med al-Faysal Al Sa'ud, a keen proponent of Islamic economics and banking who is also chairman of the International Association of Islamic Banks, in Jiddah. DMI now wholly or partly owns 21 Shari'a-based institutions in 13 countries, including eight Islamic banks, seven investment companies, three insurance firms and three business firms, with a capital investment of over $100 million. Its global operations have mobilized more than $1.7 billion in private and institutional savings, mostly from the Gulf and Saudi Arabia, where DMI has more than two dozen offices. After a brisk start, several turbulent years followed for DMI, with major losses in 1983 and 1984. Now, though, DMI has apparently turned the corner and returned to profitability. During the past two years, ending in June 1986, the Geneva-based flagship Dar al Maal al Islami Trust recorded net profits of $5.8 million and $8.4 million.
Another potential giant in the world of Islamic banking is the Al Rajhi Company for Currency Exchange and Commerce, the biggest money exchange house in Saudi Arabia. Since it received authorization, in a 1983 royal decree, to transform itself into a full-service bank operating on Islamic principles, the company has gradually expanded to provide the public with a full range of banking services, including taking deposits and making loans, at more than 275 branches throughout the kingdom. Its Islamic investments department deals mainly in top-rated bonds of foreign corporations, and in 1985 had a turnover of more than $11 billion, mostly in commodities trading. But Al Rajhi has not yet become a public company or taken a new name, as stipulated by the decree granting it commercial-bank status. When it does, it should be the second or third largest bank in the country, with a capital of over $200 million, and is likely to be called Al Rajhi Banking Investment Corporation.
The problem that many Islamic banks face - high deposits and excess liquidity with limited investment outlets - will be resolved only when Islamic banks around the world coordinate their efforts to channel excess balances in one part of the world to viable investments in another. This is already being done on a limited scale by the Al Baraka and Dar al Maal al Islami groups, and is the crux of a proposal that Dr. Sami Homoud developed in a study for the Jiddah-based Islamic Development Bank three years ago: the creation of an International Islamic Bank, jointly owned by Islamic banks throughout the world, to serve these banks as a central bank, or "lender of last resort." Dealing only with banks and financial institutions, the International Islamic Bank would channel financial surpluses to cash-poor markets and encourage trade and joint investment throughout the Islamic world and further afield. It will probably be established with a capital of $500 million, but agreement on its location is still pending.
The Islamic Development Bank (IDB) itself is another focal point of Islamic banking practices and global coordination (See Aramco World, November-December 1979). It was established in 1975 by the Organization of the Islamic Conference to undertake long-term financing of development projects. With 45 member countries, the IDB provides short- and long-term loans and equity financing for productive projects and trade deals, often co-financing them with commercial banks or other lenders. Operating according to Shari'a principles, it has applied lending and equity financing, leasing, installment sales and mudaraba trade financing. Since its founding, it has approved $6.21 billion in aid to Muslim states and communities in the form of soft loans, project and foreign-trade financing, and technical assistance.
The IDB's investment deposit scheme accepts deposits of $250,000 or more for six months or longer, to finance murabaha trade deals on which it collects a seven-percent mark-up. It also finances installment sales and plans to use the "declining participation" financing method, which many other Islamic banks have applied in domestic markets. With this method, the bank buys a share of a project's equity, is repaid from the project's annual profits, and gradually withdraws over a period of years after recovering its initial investment and a small profit.
The IDB too names as one of its current concerns the development of new Islamic financial instruments, intended not only to absorb some of the excess cash in the hands of Islamic banks, but also to redirect that money into feasible investments in other Islamic or non-Islamic countries. IDB President Dr. Ahmad Mohamed Ali, a Saudi national who has headed the bank since its inception, told Aramco World in Jiddah that "one option under consideration is to issue innovative financial certificates through mudamba funds, which are similar in several respects to conventional unit trusts, investment trusts or mutual funds, but have their own unique Islamic features."
Ali has already sounded out several member states' stock exchanges about listing and trading the Islamic certificates, one of whose attractions is that investors would know how their money is being used. Until stock-market listings are arranged, the IDB would repurchase the certificates at any time, thereby creating a secondary market and providing the liquidity that investors demand. The bank is also considering issuing Islamic CDs to raise funds for its usual trade and project-financing work; investors in the CDs would not know in what projects their money was being used.
The Islamic Development Bank has worked closely with Islamic banks throughout the world, holding regular meetings both of technical experts and of the heads of institutions, and continues to take part in discussions to establish the International Islamic Bank. IDB has also taken equity participations to help establish the Bahrain Islamic Bank, Al Baraka Turkish Finance House and Bangladesh Islamic Bank in Dakka. Its policy in such cases, Ali says, "is to help launch an Islamic bank and see it find its feet, then sell our equity stake and use the money to finance projects in other countries."
In a potentially far-reaching development or recent years, Islamic and commercial banks have begun working closely together for mutual benefit. Islamic banks with substantial funds that they cannot profitably invest have passed them on to Arab and Western commercial banks, which must use the money in a manner that adheres to the Islamic banks' Shari'a principles. The commercial banks invest most such funds in trade or commodities deals in which title of ownership passes from one person to another, and the profits are shared between the Islamic and the commercial partners.
"The Islamic and commercial banks have found out that they are serving the same function and providing the same services," a commercial banker said in Bahrain, "but we use different means to reach the same end."
Most of these cooperative deposits are for periods between three and 12 months, and serve both sides by giving the Islamic banks access to their commercial colleagues' wide client contacts around the world, while providing the commercial banks with access to a new, steady source of funds at competitive rates. An added attraction for the Islamic banks is that such arrangements provide a vital short-term outlet for cash balances that they cannot invest profitably and safely in other fields.
Dr. Homoud of Al Baraka estimates that Islamic banks' funds account for several billion dollars a year of transactions on the London metal exchange, mostly channeled through Western banks that know the business better than most Arab or Islamic banks. Money from Islamic banks has also funded equity portfolios developed for the Islamic market by important Swiss and British banks. These portfolios are essentially unit trusts that invest in the shares of companies whose work does not contravene Islamic dictates, and they significantly diversify investment outlets for cash-laden Islamic banks - some of whom, such as Al Baraka and DMI, have explored launching unit trusts of their own.
The last decade has shown that substantial numbers of consumers are attracted by what Islamic banks have to offer, and the banks, as they have drawn more deposits, have gradually developed management expertise and sophistication to match. Clearly, though, this is an industry that is still being born, and problems remain. The fact that many Islamic banks were established in the boom years of the late 1970s meant that, while still new and inexperienced, they ran into the problems of the post-1982 recession: dwindling new business opportunities, slower trade and sharply declining prices for real estate and stocks. Their difficulties have highlighted the urgency of what most Islamic bankers now agree is their immediate priority: the establishment of a global Islamic capital market that can bring together the providers and users of capital throughout the world. A global market-place would significantly increase the scope for profit-sharing investments by Islamic banks and impel them to increase the deposit-taking activities of their established networks of retail branches.
In light of this hope - and goal - for the future, the likelihood is that the Islamic banking system now taking shape around the world will continue to grow, perhaps to the point of becoming a parallel financial system for investors seeking an alternative to the existing global interest-based capital market dominated by Western banks. As the last decade has shown, however, Islamic banks and interest-based banks should not view each other as competitors, but as partners: They can complement one another's strengths and work together across national and religious boundaries for the mutual benefit of institutions and individuals in both systems.
Rami G. Khouri, journalist and publisher, is the author of The Jordan Valley - Life and Society Below Sea Level and of guidebooks on Petra and Jerash. He covers Middle Eastern economic matters from Amman for several international publications including the London Financial Times.