Thursday, 11 November 2010

Sharia Finance op-ed: more than a "moral hazard"

The article below was an op-ed contribution to the South China Morning Post, which I sent out last week.  It’s in response to an article copied below, by Andrew Sheng, the former Chairman of the Securities and Futures Commission, promoting Sharia finance in Hong Kong.

Islamic finance is hazardous to one’s health

It’s very odd to see a former Chairman of the Securities and Futures commission, Andrew Sheng, spruiking for Islamic finance and its alleged “ethical” prohibition of interest. [1]. 
Even more bizarre is his claim that Islamic might offer “great service to the rest of the world”, assuming it solves “moral hazard”.
Just a moment professor Sheng!  Islamic finance is a hazard to much more than one’s morals.
Consider some of the hazards of Sharia finance:
First, the Sharia hazard.  It is self-evident that Islamic finance is a part of Sharia, since “Islamic finance” is often known as Sharia Compliant Finance, or simply Sharia finance. [2]  Sharia jurisprudence is made up of often-draconian laws inimical to freedom of conscience, freedom of speech, and the equal rights of women and minorities.   The “Reliance of the Traveller, Umdat al-Salik”, the authoritative Manual of Islamic law makes this clear. [3]
Second, the hazard of funneling of money to terrorism.   A portion of profits from Sharia finance must be donated to Islamic charities and some will find its way to terrorists.   We know this will happen because: (i) it has already happened --  the recent Holy Land Foundation trials in the US identified 27 Islamic charities as funnels to terrorist organisations. [4] And (ii) it is called for in Sharia law –12.5% of money donated to Islamic charities must be used to promote Jihad.[5] Promoters of Sharia finance (such as professor Sheng) may play down the terrorism link, but the evidence is clear:
The 9/11 Commission Report:
“Donations [to al Qaeda] flowed through charities or other nongovernmental organizations.” [6
Stanford University:
“…terrorist groups such as al Qaeda have traditionally relied on Islamic charities for much of their funding.” [7]
The US Navy Center on Contemporary Conflict (USCCC):
The crux of the matter in combating the exploitation of Islamic charities by terrorist organizations comes down to the fact that… there is a recognized religious duty in the Muslim world to donate a set portion of one's earnings or assets to religious or charitable purposes, which in turn must donate 1/8th to Jihad activity.  [8]
USNCC provides a flow chart of how Islamic charity flows to terrorist organisations. [9]

Some observers have speculated that the clear and documented links to terrorism, via Sharia finance, may lead to legal challenges of Sharia products such as Sukuk bond, at least in US courts, for it is clear US policy to prohibit financing of terrorism.
Third, the inefficiency hazard.  Muslim professor of Economics Mahmoud El-Gamal says Islamic products, such as Sukuk bonds, are “poorly designed … grossly inferior and poorly constructed products for profit”. [10]
 They provide no innovation or economic alternatives, only exclusions.  Professor Timur Kuran has written at length about the outdated and inefficient nature of Islamic finance and documented how it has kept Islamic societies from robust growth.  And contrary the claim that Sharia finance weathered the Global Financial crisis, it has performed badly: see “Sharia finance a ‘huge flop’ in the UK” [11]. Why would we in Hong Kong want to pay for the creation of a system innately more inefficient? 
Fourth, the “ethical” hazard.  Much is made of the alleged “ethical character” of Sharia finance, and professor Sheng joins that chorus. We are supposed to buy the concept that the prohibition of interest is “ethical”, when in fact the time-value of money has underpinned western finance, (and recent ructions should not lead us to promote a system demonstrably inferior).  But there’s more to Sharia finance than prohibition of interest, or pork or alcohol products.  Sharia compliant “Sukuk” Bonds, for example, are prohibited from investing in products or construction that benefit non-Islamic religions; any project that promotes equal rights for women and gays; western defence industries (but not Muslim ones); western books, films, TV and radio.  And, of course, from any company having links with Israel. [12]
Fifth, the cost and policing hazards.  Proponents of Sharia finance such as Zaid Ibrahim & Co of Malaysia, emphasise that laws and regulations will need to be changed and that this will be an “on-going” and long-term process. [13] Laws to be amended include tax,  property, insolvency and securities laws; such amendments cost time and money.  Moreover, Zico stress there will need for Sharia finance law enforcement.  Is it right that the taxpayers of Hong Kong should pay for the creation of a religious financial system?   And that we should then police these religious laws? The Financial Services Authority of the UK has rightly decided that it ought to stay out of the minefields of promoting any one religiously-based financial system. [14]  It does so, it says, because it is secular and not a religious regulator.  Hear, hear to that.

Perhaps some of these hazards of Sharia finance are understood by the Hong Kong government.  For we have heard little of Sharia Compliant Finance since the announcement that it was planning to promote it in 2007. 

If so, then the policy of benign neglect of Islamic finance should continue, and ignore the likes of professor Sheng who is merely parroting Sharia-compliant progaganda.  To promote it is hazardous to our economic and cultural health.
Peter Forsythe was a senior Australian diplomat in Asia and founder of the Wall Street Institute in Hong Kong.  He is Director of Excel Associates, managing private portfolios.

[1] “The new challenge to Wall Street?”, South China Morning Post, 30 October 2010.  See full article below.
[2] Shariah’s “Black Box”: Civil Liability and Criminal Exposure surrounding Shariah-Compliant Finance.  David Yerushalmi. Utah Law Review, No. 3, 2008.
[3]  Reliance of the Traveller: The Classic Manual of Islamic Sacred Law Umdat Al-Salik, Amana Publishers, 1994. Available here.
[4] United States Attorney’s Office, Northern District of Texas, May 27, 2009.
[5]  Reliance of the Travelleribid, h8.17: “The seventh category [of distribution of Islamic charity, or Zakat] is those fighting for Allah,meaning people engaged in Islamic military operations for whom no salary has been allotted in the army roster.” (emphasis in the original).
[6] The 9/11 Commission Report, p 55
[7] Victor Comras, “Al Qaeda Finances and Funding to Affiliated Groups,” in Jeanne K. Giraldo and Harold A. Trinkunas, eds., The Political Economy of Terrorism Finance and State Responses: A Comparative Perspective (Stanford University Press, 2006).
[8] Looney, R.E. (2006) ”The Mirage of Terrorist Financing: The Case of Islamic Charities”, Strategic Insights, Volume V, issue 3. Here.   And Reliance, ibid, h8.17
[9]  ibid
[10Have we learnt nothing? Here come the “Islamic Credit Default Swaps”, Mahmoud El-Gamal, January 3, 2010.  Here.
[11] Sharia finance a “huge flop” in the UK, Battle of Tours, 15 August, 2010.  Here.
[12] Information from of a Doha-based Islamic finance expert, who has worked with Islamic Banks and Islamic finance with the World Bank, Islamic Development Bank and the African Development Bank.  May 2010. 
[13]  Demystifying Islamic Finance, Zaid Ibrahim and Co, May 2010. Original from Zico website here.  Copy here.
[14]  Financial Services Administration of the United Kingdom, January 2010: “The FSA’s attitude towards Shariah finance is that they will not provide any hindrances for it, nor will they provide any encouragement. This is because the FSA is secular in nature and not a religious regulator.” Here.

The new challenge to Wall Street?
South China Morning Post, 30 October 2010
Andrew Sheng
Since Donald Tsang Yam-kuen announced Hong Kong's ambitions to be an Islamic finance centre, in 2007, there have been great advances in Islamic finance. I was in Kuala Lumpur this week attending the Global Islamic Finance Forum, which was attended by the whole glitterati of the Islamic world.
In the 1990s, Islamic finance was a fledgling, fringe industry. Today it has grown from roughly US$150 billion to about US$1 trillion. This is still small relative to some of the largest global fund managers and universal banks, who manage more than US$1 trillion each. But the double-digit growth and potential size of the market cannot be ignored. Some pundits think the market will reach US$2 trillion in the next five years.
There are roughly 1.3 billion Muslims in the world, with 138 million in India and roughly 30 million in mainland China (plus 200,000 in Hong Kong). These are growing markets in terms of income and wealth. Since the Muslim community wants to invest in interest-free banking, Islamic funds have been growing in leaps and bounds. There are roughly US$800 billion in Islamic banking funds, US$100 billion in the sukuk (or Islamic bond) market and another US$100 billion in the takaful (Islamic insurance) and fund management business. In 2008, Hong Kong sought to attract Muslim investors by introducing the Hang Seng Islamic China Index Fund, which complies with sharia law.
With oil prices remaining at high levels, Middle East producers continue to generate surpluses that must be parked somewhere. With Western markets and economies under pressure, some of that money has moved eastward.
Will Islamic finance be a serious challenge to traditional Wall Street finance? That question deserves a good answer.
First of all, thanks to the good work of Bank Negara Malaysia and the central banks of Persian Gulf nations, the infrastructure for Islamic finance has been laid. It includes the establishment of an accounting standards authority (the Accounting and Auditing Organisation for Islamic Financial Institutions); an international organisation to set regulatory standards (the Islamic Financial Services Board) and the Institute for Education in Islamic Finance. (**)
The basic principle of Islamic banking is the sharing of profit and loss, and the prohibition of usury. Simply put, interest is prohibited, but profit sharing is not. The distinctive elements of Islamic finance are its ethical aspect (the prohibition of usury and exploitation of the borrower), the preference for trading in real assets (rather than synthetic products), partnership between the investor and investee, and its governance structure (requiring a sharia council).
The point to remember in Islamic finance is that there is no Islamic global reserve currency. Although Islamic banks are growing rapidly, there is no assurance that they will not be subject to the problems of non-performing loans and bank runs that are endemic in commercial banking.
This week saw the launch of the innovative International Islamic Liquidity Management Corporation (IILM). It aims to help institutions that offer Islamic financial services to manage liquidity more efficiently and effectively. It addresses a fundamental problem of Islamic financial institutions: providing adequate liquidity in times of stress. Once an international lender of last resort is in place (to supplement national facilities, not replace them), there will be better confidence in the liquidity of the Islamic financial services industry.
The IILM is expected to issue high-quality, sharia-compliant financial instruments at both the national and cross-border levels, to enhance the soundness and stability of Islamic financial markets.
The signatories to the IILM Articles of Agreement are the 11 central banks or monetary agencies of Indonesia, Iran, Luxembourg, Malaysia, Mauritius, Nigeria, Qatar, Saudi Arabia, Sudan, Turkey and the United Arab Emirates. Multilateral organisations participating in the initiative are the Islamic Development Bank and the Islamic Corporation for the Development of the Private Sector.
Islamic finance has come a long way, but there is still a long way to go, since US$1 trillion is still small relative to US$232 trillion in conventional financial assets (excluding derivatives).
The real test for any challenger to Wall Street finance is whether Islamic finance will be the more efficient, more ethical and more stable of the two. Islamic finance fulfils the needs of the Islamic customer. Ethics aside, there are two crucial problems in finance - information asymmetry and the principal-agent relationship. Because markets are not completely transparent and information is unequal among participants, we tend to rely on trusted institutions such as banks (the agents), to act on our (the principals) behalf.
The recent Wall Street crisis demonstrated how complex financial engineering enables very smart bankers to make profits at the expense of the public purse. When they fail, the public bears the losses because they are too large and too powerful to fail. This is the 'moral hazard' created in the absence of the level playing field that is a precondition of free markets.
The real question is, given our unequal access to information, how do the savers and borrowers know when the banks have shifted the risk back to them, because of moral hazard? Islamic finance faces exactly the same dilemma. If Islamic finance theoreticians can solve this problem, they would be doing a great service to the rest of the world. Then we would truly have an alternative to Wall Street.
Andrew Sheng is a former chairman of the Hong Kong Securities and Futures Commission and current adjunct professor at Tsinghua University's School of Economics and Management, Peking
** PF comment to para 6 above: Oversight bodies of Sharia finance include a number of known Jihadists.  Mufti Taqi Usmani, for example, is Chairman of the Sharia board of the Accounting and Auditing Organisation for Islamic Financial Institutions, AAOIF, the Sharia finance accounting standards body.  Usmani he has been banned from travel to the United States and the UK for his financial ties to Jihadist terrorist organisations.  Sheikh Yusuf al-Qaradawi sits on the board of some major Sharia finance institutions.  He also runs the charity Union of Good, which the US Treasury has designated a terrorist entity. Qaradawi has called Sharia finance “Jihad with money”.  There are many other gentlemen (it's always men!) of similar outlook sitting on Sharia finance bodies throughout the world, including on the very regulatory bodies professor Sheng lauds.