How Does Islamic Finance Protect Investors?

The transparency and structure demanded of Islamic finance that is attracting investors burned by the plethora of financial crises could well have provided warning signals of the impending debt turmoil.

The subprime crisis has seen an exodus from riskier asset classes, partly as investors veer away from sophisticated products like collateralized debt obligations.

According to the IMF following paper on the IMF website, Islam prohibits transactions based on Gharar (uncertainty in transactions), Maysir (gambling or the acquisition of wealth by chance instead of effort), and Riba (interest rate). These principles are beneficial for financial stability and consumer protection.

How Do Islamic Finance Protects Investors?

Investors say Islamic finance products demand greater transparency and accountability from company management, so it would be more obvious when companies are getting into debt problems.

Under Islamic finance, the lender is also an investor, so he remains an active participant through the life of the transaction and is in a position to rectify mistakes before the situation worsens, bankers say.

This appeal has added to an exponential growth in Islamic finance

Global bond and loan offerings issued according to Islamic guidelines have jumped 64 percent, to $5.5 billion so far this year, data from Thomson Financial show.

Islamic finance assets are growing at an annual pace of 20 percent and are set to hit $2 trillion in 2010 from the current $900 billion, fueled in part by a flood of petrodollars generated by the rise in energy prices.

Islamic finance principles stipulate that deals must be based on tangible assets and require tight controls on debt levels, features analysts say offer some protection to investors and ensure corporate accountability.

“At the core of the current subprime crisis is the securitization of subprime mortgages or debts, a concept that would generally not be acceptable from a Shariah perspective,” said Arshad Ismail, Dubai-based head of Islamic finance at HSBC Amanah.

He said Shariah-compliant financing also avoids transactions that have an element of speculation and those that are not asset-based, thus providing investors with built-in safeguards.

These features provided early warnings to investors before such corporate debacles as the collapse of Enron and WorldCom.

Both companies were part of the Dow Jones Islamic Market index, which has a screening process under which constituents with unacceptable financial ratios are removed from the benchmark.

That happened to Enron and WorldCom.

“They were excluded from the DJ Islamic market index months before the crash – the high level of debt indicated ineffectiveness of control,” said Aznan Hasan, Shariah adviser to the investment bank Aseambankers Malaysia Berhad.

Hasan said that securitization was not permissible under Islamic finance like in conventional debt and that the screening process demanded that a lender could see tangible assets and business activity from a borrower.

“You don’t simply give loans to the client, allowing him to do whatever he wants, and this can have a lot of impact on credit vigilance,” he said.

But Hooman Sabeti, Islamic finance specialist with the law firm Allen & Overy, argues that Islamic finance products do not necessarily give investors significantly higher protection.

“You might end up with title rather than security over the asset, and that might put you in a slightly better position, but it’s not that different,” Sabeti said.

Under Islamic finance, the lender might end up outright owning an asset rather than having security over it, but the economic effect is almost the same, he said.

“The reason why the Islamic finance market is an attractive market now is because of high liquidity in the Middle East, and investors haven’t been as burned like in the U.S. or Europe, so they don’t have the same negativity or sentiment,” he said.

And though these buyers of conventional assets may no longer be investing in their home markets, some are gravitating to Islamic finance, a move that is benefiting issuers.

“When we structure it the Islamic way, we can keep the existing conventional people as well as get the Islamic lenders, so that opens up a much bigger market for us and that results in lower pricing,” said Karl Marietta, deputy chief executive of National Central Cooling.

Author

Hafiz M. Ahmed

Hafiz Maqsood Ahmed is the Editor-in-Chief of The Halal Times, with over 30 years of experience in journalism. Specializing in the Islamic economy, his insightful analyses shape discourse in the global Halal economy.
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How Does Islamic Finance Protect Investors?

How Do Islamic Finance Protects Investors?

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How Does Islamic Finance Protect Investors?

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