Khan in SmartMoney – Hobart and William Smith Colleges \
The HWS Update

Khan in SmartMoney

Feisal Khan, assistant professor of economics, was featured in SmartMoney magazine, discussing Islamic finance. The article “Has Islamic Banking Outgrown Islam?” looks at the practices of Islamic banks and their similarity to conventional banks.

It quotes Khan, “If you are satisfied saying ‘markup’ instead of ‘interest’– if that’s all you care about — it’s Islamic. If you care about the substance, it’s not Islamic.”
The article notes Khan previously worked as a corporate banker in his native Pakistan, and recently published a paper in the September issue of the Journal of Economic Behavior and Organization, on the 30-year disconnect between Islamic finance theory and practice. The paper is titled, “How ‘Islamic’ is Islamic Banking?” and the SmartMoney article says Khan’s conclusion is “Not very.”

Khan joined the HWS faculty in 2000 after earning his B.A. and M.A. from Stanford University and his Ph.D. from Southern California.

The full SmartMoney article follows.

Has Islamic Banking Outgrown Islam?

By the Numbers • Jack Hough • October 22, 2010

Islamic finance is growing fast–but has it outgrown the principles of Islam?
Assets at Islamic banks in major Muslim markets like Saudi Arabia and the United Arab Emirates swelled 32% from 2007 to 2009, versus 13% for conventional banks in the same markets, according to a September paper by the International Monetary Fund. In the U.S., more than a dozen companies offer primarily Shariah-compliant banking products.

For most large Islamic banks, however, at least three-quarters of — and in some cases nearly all — transactions are Islamic in name only, according to a new study. In practice they closely resemble the conventional bank products that are off limits to devout members of the faith.

“If you are satisfied saying ‘markup’ instead of ‘interest’–if that’s all you care about–it’s Islamic, says Feisal Khan, an economics professor at Hobart and William Smith Colleges in upstate New York. “If you care about the substance, it’s not Islamic.”

Khan, who once worked as a corporate banker in his native Pakistan, documents the 30-year disconnect between Islamic finance theory and practice in a paper published in the September issue of the Journal of Economic Behavior and Organization, titled “How ‘Islamic’ is Islamic Banking?” His conclusion: Not very.

There’s no worldwide body that creates rules for Islamic finance. Most practitioners agree that the charging of riba (literally increase) on money is forbidden, and that the sharing of risk and reward is not only encouraged, but required. Mohammed was, after all, a merchant. Transactions should be based in the real, material economy; that is, no derivatives. Also, they shouldn’t be used for sinful activities.

“America’s venture capitalists offer a good model for Islamic finance without knowing it,” says Khan, because many of their transactions involve shared risk and profit. Islamic banks use some of the forms of venture capitalism, but profit-sharing doesn’t work well for the purchase of things that don’t produce profit, like refrigerators, cars and owner-occupied housing. So banks use “legal sophistry to get around the interest ban,” says Khan.

Consider car financing. A typical bank charges interest for a car loan. Many Islamic banks use an arrangement called a murabaha: The bank buys the car on behalf of the customer, and then sells it to him at a markup, with payment collected in installments. Spread over the payback period, the markup looks a lot like interest rates on typical car loans.

House financing offers another example. Conventional banks use interest-based mortgages. Islamic banks typically use something called a musharaka, whereby they enter a joint venture to purchase the house for the buyer, who gradually buys out the bank’s share, while paying rent–the rate of which tends to closely match prevailing interest rates on mortgages.

Islamic banking arose in the mid-1970s, fueled by a quadrupling of oil prices, which left Gulf states flush with cash, and the spread of pan-Islamism, which drove Muslims to seek their own alternatives to conventional finance, according to Ibrahim Warde, a Tufts University professor and author of “Islamic Finance In the Global Economy.”

“There was a lot of utopian talk about creating a new financial system, but over the past 30 years Islamic banks have had to be pragmatic and operate within the real world,” says Warde. “So you end up with some rhetoric giving things different names.”

Warde compares the financial contortions of today’s Islamic banks with the contractum trinius used by medieval Christians to circumvent the church’s ban on interest. It consisted of three contracts–an investment, a sale of profit and an insurance policy–each of which was permissible on its own but when combined mimicked an interest-bearing loan. The Christian ban on interest dissolved during the Protestant Reformation. The Muslim ban did not.

Fees for Islamic financial products are generally a little higher than those for conventional ones, say Khan and Warde, owed to the smaller scale of the system, the added cost of clerical supervision and the need for more paperwork, such as when many equipment markup transactions are used for a business instead of a single line of credit.

As with all banking, there’s also the occasional shady dealer. “There are some people who call themselves Islamic who really are nothing but brokers,” says Yahia Abdul-Rahman, founder of Lariba, an Islamic finance company in Pasadena, California. “You call and they say they’ll charge you 4.2%, but they don’t tell you about the fees–administration fees, partnership fees, limited liability company fees, rate-locking fee, application fee–and you end up at least half a point higher.”

Abdul-Rahman says Lariba offers competitive rates and that unlike some Islamic banks, it bases its house financing on actual market rents, not rents that are contrived to match mortgage rates. When and where prices are high relative to rents, it turns down transactions because its return on investment would be too low. As an added benefit, that practice helped it avoid big losses during the U.S. housing bubble that peaked in 2006. High price-to-rent ratios are a classic sign of a bubble.

Islamic banks are gaining recognition for some other side benefits of their practices. Their focus on material transactions left them relatively free of the toxic assets that plagued Western banks in recent years. Also, their shunning of leverage constrains their growth but keeps their balance sheets relatively strong.

Ultimately, the question of the Islamic-ness of today’s Islamic banks might be less important than the question of whether the best ones offer a template for socially palatable finance in all faiths. Abdul-Rahman, who wrote a book titled “The Art of Islamic Banking and Finance,” published in January, says he now uses the term riba-free rather than Islamic to describe Lariba, because it’s “based on a Judeo-Christian-Islamic values system,” and many of its customers are non-Muslim.

“We believe the first riba-free banker in the U.S. was Jimmy Stewart in ‘It’s a Wonderful Life,'” he says. “That’s what a community banker is about.”