December 7, 2011 — Islamic law prohibits the charging of interest by lenders, requiring banks to directly invest in actual assets or services. This leads to the sharing of both risk and reward, profit and loss between the borrower and lender, which would have prevented the recent global financial meltdown.
That's one major idea prompting a new interest in Islamic finance, including among University of Virginia students who this semester created the U.Va. Islamic Finance Association.
"Everyone is suddenly becoming more aware that we should question our current financial system, and there should be other ways to better serve people," explained Alejandro Alcala, a second-year anthropology major in the College of Arts & Sciences and a leader of the association.
Islamic finance provides an alternative view of what a financial system can and should be, which encourages students to question whether the conventional Western financial system is providing certain social goods and how the system could be improved, explained the group's founder and president, Haroon Masood, who lived most of life in Saudi Arabia and whose father spent 20 years working for Citibank in the Middle East.
"There are very few places where students get to question fundamental assumptions and come up with new ideas and solutions," said Masood, a second-year student who hopes to attend U.Va.'s McIntire School of Commerce.
A handful of universities, including Harvard and the University of Pennsylvania, offer courses on Islamic finance, "but none of them have student organizations that aim to place students at the forefront of this field," Masood said. "We want our organization to become the hub for learning and innovation in Islamic finance in North America."
The association recently took its first major step toward that end, hosting U.Va.'s first Islamic Finance Forum Nov. 21 at the McIntire School. The forum, sponsored by the McIntire Center for Financial Innovation, was headlined by two leading experts in Islamic finance: Zamir Iqbal, the lead investment officer in the Quantitative Strategies, Risk, and Analytics Department in the Treasury of the World Bank; and Michael J.T. McMillen, a managing director at the private equity firm Riverstone Capital, who twice has received Euromoney Magazine's award as the best legal adviser in Islamic finance.
"If you pick up a popular journal or magazine article on Islamic finance, the primary message you'll come away with is 'no charging interest,'" Iqbal said during the forum. "But there's more to it than that."
Indeed, he explained, the rules governing Islamic financial practices are rooted in the Quran's values, designed to promote economic justice, community unity and social harmony.
Flowing from those values, Islamic financial transactions are characterized by profit- and risk-sharing instead of usury; investments tied to tangible assets; and a ban on speculative contracts like conventional derivatives. Islamic banking also must comply with Islamic law, which precludes transactions supporting the production of alcohol, tobacco, pornography and the like.
The prohibition on charging interest, Iqbal said, seems to most flummox Westerners. In the early 1970s, as an Islamic financial sector began to emerge, "people laughed" at the notion of creating a debt-free financial system, he told the audience of about 60 people. "They said, 'How can a financial system be designed without the use of interest?'"
The solution is actually extremely simple, Iqbal explained: risk- and reward-sharing, and the presence of tangible assets throughout the investment process.
McMillen, who has helped design scores of Islamic financial deals in such industries as electricity, petrochemicals and mining, gave a simple hypothetical example. An aspiring but undercapitalized merchant seeking to buy $100 worth of sesame seeds would get a $100 loan, at some interest rate, from a Western bank. In contrast, an Islamic bank might buy the seeds for the merchant, who would gradually repay the bank through a series of payments. With each payment, the merchant would gain an equity share of ownership of the seeds.
The prohibition on interest leaves Islamic financiers free to use a number of financial structures – including partnerships and leveraged leases – that are familiar to Westerners, Iqbal noted. "It's not a matter of Islamic versus non-Islamic," he told listeners. "It's a matter of financial engineering."
McMillen, too, stressed the deep commonalities between Islamic and Western methods of finance. In many ways, he said, Islamic financial practices are little different from those espoused by the West's increasingly popular "ethical" investment funds.
"You know more about Islamic finance than you think you do," he said. "There are more similarities to Western finance than there are differences."
Student Alcala concurred.
"I don't get caught up with the label of 'Islamic finance,'" he said. "I think of everything as financial engineering, and we need some new financial engineering to address the problems of the global economic downturn.
"Today in finance we accept so many things as truth or just how things are. But Islamic finance presents some different solutions to some of these problems."