This is one of the core tenets of Islamic finance, a framework rooted the Qur’an and Hadith, the sayings of the Prophet Muhammad, that over the past four decades has been mapped onto the global financial system. Its growth has been tenfold since the early 2000s, and although it is projected to reach $3.5 trillion in assets by 2024, that constitutes a bit less than 2 percent of the total volume of global financial markets. The first commercial Islamic banks launched in the United Arab Emirates and Saudi Arabia in the mid-1970s, and today nearly 300 Islamic banks do business in more than 80 countries. In places like Malaysia, Indonesia, Turkey and Pakistan, governments have laid proactive ground rules to serve not only Muslim-majority populations, but also to attract outside investment.
“People said ‘You’re crazy,’ and ‘You’re going to pay more’ ... [but] every time either there is a recession or the signs of a recession, I default back to the arguments I was forming in my head back then.”
—Naoman Malik, financial consultant
Even though Malik, now a professional financial consultant, grew up in a family that had avoided debt and interest everywhere they could, he says that at first, he didn’t see much difference in the contract terms offered by Guidance Residential, an early provider of Islamic mortgages, and those offered by conventional banks. Some of his Muslim friends were skeptical, too, he says.
“A lot of people said ‘you’re crazy,’ and ‘you’re going to pay more,’ that it’s just a traditional, Western-financed mortgage in sheep’s clothing,” Malik says.
Today, looking back from the couple’s same home, which they have refinanced twice with the lender they ended up signing with, LARIBA American Finance House, Malik says he feels a sense of peace in staying as far away as possible from the red lines drawn out in the Qur’an.
And even at the time, it was clear to Malik that Islamic principles—eschewing interest, investing in tangible or productive assets, sharing both risk and upside through partnership and showing concern for one’s community—could have averted the financial contagion that infected US subprime mortgage market and mutated around the world. There would have been no derivatives based on paper alone, and there certainly would have been no subprime mortgages.
Teaching about Islamic finance helps students “imagine a world in which things could be different.”
—Lee Ann Bambach, Emory University School of Law
“Every time either there is a recession or the signs of a recession, I default back to the arguments I was forming in my head back then,” Malik says of how insidious the system had become. “There was a smoking gun. You knew exactly what the causes were. You could see the domino effect.”
Fifteen years later, in the wake of the COVID-19 pandemic that is inflicting another generational shock to the world economy, more turbulence seems to be on the horizon. In the US and elsewhere, housing costs are soaring, inflation is breaching 9 percent, and rising interest rates are forcing a reckoning for the valuations of high-flying stocks. A correction, if not a recession, looms.
Industry experts say that these storm clouds could once again showcase the structural resilience of Islamic finance, which they argue is built to combat exploitation and limit speculation, to the long-term benefit of the consumer, the financial institution and the community.
“In Islamic finance, the party that has the ability to assume the higher risk should do that,” says Ghiyath Nakshbendi, who spent 30 years in business before becoming a professor of finance at American University’s Kogod School of Business, Washington, DC. “For example, you and me, as the poor borrowers, in conventional finance, we assume the higher risks of our loans than the bank. In Islamic finance, we say this is the opposite, because the bank can bear it. You and I cannot.”
A Muslim Mortgage
At the time Malik and Faruqi assumed their mortgage with LARIBA—the name is a compound of la, Arabic for “no,” and riba—the Islamic mortgage model was only a few years old, in contrast to broader investment frameworks that had been evolving for decades.
In the early 2000s, representatives of the greater Detroit area’s growing Muslim community approached University Bank, which for more than a century has served customers from its base in Ann Arbor, Michigan, and has recently received federal recognition for service to its community. Could the bank, community members asked, offer options that aligned with Islamic faith? University Bank CEO Stephen Lange Ranzini felt compelled to respond. “It was a true unmet need of the community,” he says.
“We have seen lower loss rates and lower default rates ... like an order of magnitude lower.”
—Stephen Lange Ranzini, CEO, University Bank
In 2002, University Bank opened a window focused on Islamic finance in one of its branches. Three years later, to meet rising demand, it stood up University Islamic Finance Corporation (UIF).
While Ranzini believed in the product, the business model was still largely unproven, says Aijaz Hussain, who worked for Guidance Residential before joining UIF in 2011. The move touched off political backlash at a time when negative associations with practices based on Shar’ia, or Islamic guidance, were widespread in the US public, and skeptics abounded even inside the Muslim community, he says.
“It was very challenging at the beginning because Islamic finance was just starting off in the US, and every place you went, there was a lot of pushback: ‘Isn’t it the same thing? Aren’t you guys just changing names, just calling interest profit?’” says Hussain, now an executive vice president for UIF in Chicago.
UIF stayed patient, and again later through the 2008 crisis, reinvesting income generated by residential loans into the business. It eventually began turning a profit on its Islamic portfolio, which proved resilient in the natural experiment offered by the mortgage meltdown. At a time of record foreclosures in the broader US, UIF saw very few defaults. Over time that trend has stayed true.
“We have seen lower loss rates and lower default rates on our Shari’a-compliant, faith-based portfolio than on our conventional portfolio, and it’s materially lower, like an order of magnitude lower,” Ranzini says. “If the world were run under the principles that we’re discussing here, there would not be as many or as severe financial crises. Period.”
That same idea has proven true at LARIBA, which had already been two decades into providing what it calls “riba-free” or “RF” loans when the 2008 crisis rolled around. The group had been founded in the 1980s by Muslims in Dallas who pooled money to build the city’s first Islamic center without the use of interest-based loans. Though new at the time in practice, LARIBA Chairman and CEO Yahia Abdul Rahman says its model could be seen as having a popular American cultural precedent.
“It became a matter of coming up with thresholds that will allow you to still invest and have a diversified portfolio.”
—Monem Salam, Executive Vice President, Saturna CAPITAL
“I consider the first riba-free banker in the US to be George Bailey, the character played by Jimmy Stewart in It’s a Wonderful Life,” says Abdul Rahman. (In the classic holiday movie, Bailey runs a local bank that, through community goodwill, staves off default and takeover by Mr. Potter, an exploitative lender and homebuilder.)
Abdul Rahman arrived in the US as a young chemical engineer from Egypt in the 1960s. He says he backed into the financial world through community activism, having helped start the Industrial Bank of Kuwait and then managing one of the first Islamic stock portfolios in the US for Citibank.
As he worked and learned, he came to believe that riba-free banking could do two important things: help families build wealth while hedging against risk and empower the broader Muslim community to achieve greater self-sufficiency as a minority.
However, until the early 2000s, riba-free mortgages were offered only infrequently, and they carried hefty down-payment requirements. That eased when LARIBA received approval for its mortgage-backed securities from Freddie Mac and Fannie Mae, the US government institutions that buy loans from banks to provide liquidity and stability in the mortgage market. In 1998 LARIBA had bought Bank of Whittier (California) to be able to take deposits, restructuring the institution around Islamic principles, and Bank of Whittier now manages assets of about $180 million with customers of diverse backgrounds and faiths.
“I don’t hold the keys to paradise,” Abdul Rahman says he tells his customers. He is careful to point out how Islam’s prohibition on usury overlaps with principles in both Judaism and Christianity as well.
“It was very challenging at the beginning because Islamic finance was just starting off in the US, and every place you went, there was a lot of pushback: ‘Isn’t it the same thing? Aren’t you guys just changing names, just calling interest profit?’”
—Aijaz Hussain, Executive Vice President, University Islamic Finance Corporation
LARIBA’s proprietary underwriting model, he explains, uses istithna’, a contract type in which the customer immediately gets the property’s title but gradually buys out LARIBA’s right to the home’s rental income, known as usufruct.
To ensure LARIBA’s investment (“loan” in conventional terms) is funding an income-generating asset, LARIBA’s algorithm calculates the home’s potential per-square-foot rental rate against comparables in the neighborhood, basing its own rate of return off the result. It then determines a monthly payment schedule based on the borrower’s share in the property and the agreed-upon term. LARIBA may lower its own payment requirement to compete with conventional banks, and it guards against bubbles by aligning its prices to those of commodities like gold and agricultural staples.
These equations have served to keep LARIBA—and other riba-free banks, as well as their customers—out of risky deals, Abdul Rahman says.
“During the peak of national delinquencies of 2008 to 2010, our delinquency rates were less than 1 percent, which was approximately one-tenth of the national average. This triggered the attention of Fannie Mae management and private mortgage insurance companies to visit us and ask: ‘How did you do it?’” Abdul Rahman says, adding that some customers called in amid the crisis to thank the bank for turning down their loans.
Investing with Islamic Finance
Compared with consumer lending, in equities and securities, it is easier to see how Islamic finance shares risks and rewards, and how it more sharply defines its boundaries. Investment managers even have their own Islamic contract type: mudarabah, wherein one party contributes capital, the other labor.
Islamic investing has a long historical precedent, points out Monem Salam, an executive vice president for Saturna Capital Amana Mutual Funds Trust, the largest set of shari’a-compliant mutual funds in the US. Historians acknowledge that the principles of musharakah, or cost- and profit-sharing partnership, likely influenced the contract Christopher Columbus signed with Catholic monarchs Ferdinand and Isabella before he set sail west across the Atlantic in 1492. According to a 2007 article by Drake Bennett in the Boston Globe, the contract was drawn up by Islamic legal scholars whose traditions had structured the economy and administration of much of the Iberian Peninsula over its seven centuries of Islamic rule.
Maneuvering Toward Resilience?
Even among experts, Islamic finance can be fraught with controversy. Do the mortgage contracts truly share risk and reward as required in musharakah, or partnership? Which musharakah terms promote this best? Does tawaruq, the practice in which metals and other commodities can back a loan, value form over substance? What guidelines are needed?
Proponents contend that the results are proving worth the efforts.
Reports have shown that at least by some measures, Islamic banks best their conventional counterparts in resiliency during times of volatility. One 2010 survey by the International Monetary Fund looked at the performance of 120 Islamic banks across jurisdictions like Turkey, Saudi Arabia, Jordan and Kuwait. The agency concluded that by minimizing leverage, the banks’ profits were insulated from the worst of the 2007-’09 crisis. But not all was rosy: Over the longer term, their real estate holdings dragged on earnings as property values fell, and without the benefit of interest-bearing deposits, many struggled to meet obligations and grow loan portfolios.
But Islamic finance proponents look beyond this: While no system will prove infallible, a focus on tangible investments grounded in real assets, along with a resistance to speculation, sets up a system that self-selects for healthier financial practices.
“If the financing that exists in the world went to productive things only—buildings, equipment, plants, machinery, infrastructure, whatever—and you eliminate all the financial engineering, there would be less demand for capital, the cost of capital would be lower to true entrepreneurs and people building companies, and you would actually accelerate the growth rate of the global economy,” says Stephen Lange Ranzini, CEO of University Bank.
It would have been like funding a startup, Salam points out, noting that partnerships make sense for ventures in which the risk for both sides is high and the reward unknown.
Equity investing in stocks and mutual funds also fits naturally into the Islamic ethos of partnership, but it has taken a few decades for Islamic scholarship on the topic to catch up with modern markets, says Salam, who spent the seven years leading up to 2018 working as president for Saturna Capital’s operations in Malaysia, a country which is seen as a model for parallel regulation of Islamic and conventional finance.
There is not only the sharing of risk but also the matter of what one invests in. The Qur’an and Hadith state clear prohibitions against investments in pork, alcohol, gambling or any other activity that is expressly forbidden, along with investments in companies that generate interest from their savings.
But at the same time, under Shari’a, what is not specifically prohibited is permitted. Thus gray areas abound. Islamic scholars have issued decades of interpretations that have, for the most part, widened the pool of available investments.
“It became a matter of coming up with thresholds that will allow you to still invest and have a diversified portfolio,” Salam says.
For instance, companies whose main business activity is not forbidden (like an airline) can generate up to 5 percent of their revenues from forbidden activities (such as serving alcohol on flights) and still can be seen as “investable” by Islamic standards. Amana allows companies it invests in to carry debt of up to 33 percent of their market capitalization.
“During the peak of national delinquencies of 2008 to 2010, our delinquency rates were less than 1 percent, which was approximately one-tenth of the national average. This triggered the attention of Fannie Mae management and private mortgage insurance companies to visit us and ask: ‘How did you do it?’”
—Yahia Abdul Rahman, chairman and CEO, LARIBA
Finding investment targets has grown easier with enhanced reporting requirements and online search capabilities, Salam says. This is partially responsible for the relatively rapid growth of Islamic investing as a sector since the 1980s, when Amana was helping to pioneer the space. A seminal moment arrived with what Salam and others call the “Dow Jones fatwa” of 1998, when Islamic scholars from around the world hammered out the foundational guidelines for shari’a-compliant investing in public equities to create the Dow Jones Islamic Index.
Amana’s measured approach, emboldened further by clearer Islamic scholarship, saw many investors—including more than a few non-Muslims—flock to Amana as a safe haven during the 2008 crisis, as its assets under management across its first three funds more than doubled during the period from $1 billion to about $2.6 billion. The Amana Participation Fund was launched in 2015, and now the trust has $3.5 billion under management across four funds.
It’s hard to generalize that in times of crisis, Islamic funds do better than the overall market, but there is evidence, says one economist at a Jiddah-based bank in Saudi Arabia who for privacy asked not to be named.
“‘Outperformance’ is a relative term,” he says, but “any stock in a shari’a-compliant fund has to be from a morally upright, ethical industry and financially disciplined. This helps Islamic equity investments perform better during the economy’s downturn,” he explains. “Similarly, for lending institutions, financing to the real economy helps them stay away from exotic derivatives like instruments for hedging or trading. Therefore, these are more conservative.”
Amana’s funds have borne this out during recent periods of volatility, but it’s only clear in hindsight, Salam says. “For a long time you can be wrong,” he adds, noting that in the low interest rate environment of the 2010s Amana’s Income Fund looked like it was leaving money on the table by not funding riskier firms. But during the crisis of 2007-’09, Amana’s Growth Fund and Income Fund dropped just 6.9 percent and 5.4 percent, respectively, while the S&P 500 fell 20.32 percent.
Performance since COVID-19 began has been more mixed. The Amana Growth Fund jumped 74.7 percentage points in the two years ending in December 2021, outpacing the S&P 500’s 52.4-percent increase. The Amana Income Fund grew more slowly at 39.4 percentage points. All have fallen since that peak at various rates, but Salam believes Amana’s funds are positioned well as more uncertainty gathers on the horizon.
Overall, Islamic finance has become a model for what a more inclusive, responsible global financial system could look like, says American University professor Nakshbendi.
“Simply put, Islamic finance is for humanity,” he says, noting that what he refers to outside Muslim circles as “alternative finance” could show considerable mass appeal, especially if Islamic banks from outside the US would become bolder in showcasing their practices using pilot projects in places like New York or Washington, DC.
“Islamic finance has become a model for what a more inclusive, responsible global financial system could look like.”
—Ghiyath Nakshbendi, professor of finance, Kogod School of Business, American University
Students in the Kogod School of Business, where Nakshbendi introduced the first graduate certificate in Islamic finance in the US, admire the way the practice overlaps with their “adopted mantras” of corporate social responsibility and compassionate capitalism, and the rising resonance of environmental, social and governance (ESG) concerns, as well as firmer stances on social issues like race relations and climate change. He also points out that Islam’s prohibition against usury resonates particularly strongly with students in the US facing daunting debt burdens that cumulatively total about $1.7 trillion, a figure that exceeds the nation’s outstanding credit card debt.
Lee Ann Bambach, an adjunct professor teaching Islamic finance and researching religious dispute resolution at the Emory University School of Law in Malik and Faruqi’s home city of Atlanta, has similarly seen how teaching Islamic finance helps her students “imagine a world where things could be different.”
She believes Islamic finance will see more uptake when its principles are evaluated more frequently outside of their original religious context. With her students, she illustrates her point by drawing an analogy with Jewish food requirements: Oreo cookies, she says, are labeled kosher, but that’s not why most consumers buy them. “I think that’s the future of Islamic finance, at least in the United States,” Bambach says.
Ranzini of University Bank makes a similar point, but with a chicken shawarma. The halal, or Islamic-compliant, and conventional versions may look and taste the same, but how the meat was slaughtered is of vital importance to the devout diner. The same concerns and conclusions are increasingly applied in other sectors, from organic foods to clothing, packaging, energy and more.
“How you manufacture your product actually matters. You wouldn’t want to incorporate unethical features into a product, so once people start to understand that, then it becomes more clear,” says Ranzini.