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Bottoms-Up vs Top-Down Approach

Islamic finance is a scam. 

It’s more expensive than conventional financial products.

It masquerades itself as being shariah-compliant with trickery using arabic names.

This is what you often hear about Islamic finance and Islamic banking.

Before you criticize however, it’s important to have knowledge on the subject. When a number of respected scholars are signing off on these products, you shouldn’t be so quick to denigrate their work.

There are often exceptions that Islamic scholars use to give permissibility to certain ways of financing. Remember Islamic finance is not set in stone. The essence is clear but there are nuances we must take into account.

How do we deal with a shariah-compliant solution that would be impractical due to lack of regulation and overtaxation?

Before you jump on the bandwagon to call Islamic finance a joke, take a step back.

Personally, I like to humble myself and remind myself that I haven’t done the necessary studies relating to the Qur’an, the hadiths and jurisprudence (fiqh) to be able to question the decisions of these scholars.

On top of that, what Islamic scholars approve of and what certain banks and institutions push and sell is another thing. 

Heaven’s Bankers, a book by Harris Irfan, gives an eye-opening account of the friction between Islamic scholars, their fatwas and the institutions that rely on them to issue shariah-compliant investments.

Safe to say however, the industry is far from perfect.

Islamic banking, as paradoxical as it sounds, still relies on the traditional financial system. They can’t operate without the very tool that keeps the heart of the banking system beating: interest rates.

Which is why Islamic banking is a bit of an oxymoron.

Banks don't always have enough cash on hand. Sometimes they need to borrow money from other banks. They do this through what’s called the inter-bank market

It’s regarded as very safe, and banks happily lend to each other at the risk-free rate (the lowest interest rate possible). These are usually very short-term loans which are often settled in a matter of hours or days to cover immediate cash needs.

Islamic banks also need to resort to using such loans whenever they need immediate liquidity.

The modern banking system relies on credit creation as a profit driver. I’ve discussed this in previous articles. Remember, the banks are responsible for adding new money into the system.

Islamic banking uses a similar business model.

Islamic banks haven’t created anything novel. They’ve tried to rely on Islamic rulings and create an alternative banking system but this is impossible given our current monetary system.

A bank in Qatar will need to access the international banking system. It can’t escape riba.

To the point that these Islamic banks have modeled their institutions using traditional banking.

Inter-bank liquidity, which is typically done at interest, has been replaced with what we call a “commodity murabaha” or “tawarruq”.

A typical murabaha is simply cost-plus financing. You want to buy an item that you can’t afford. I buy it for you and sell it to you at a higher price but I accept to be paid back in installments over time.

For example, you want to buy a house worth $1m but you don’t have the funds. You approach someone with capital and they agree to buy the house to sell it to you with a mark-up. They buy it for $1m and sell it back to you for $1.2m. In return, you request that you’ll pay them back in installments over a 10-year period.

In this case, the mark-up of $200k replaces the interest rate.

Many will scoff at this and think it’s the same thing.

Not really. Interest rates fluctuate. With a typical mortgage your monthly payments will vary as interest rates go up and down.

In this case, the end-buyer of the house knows exactly how much they owe and how much they will have to pay.

Another point is that here we are transacting in an actual good, even though at different prices. Money is not being traded, as we would typically see when it comes to using a mortgage to purchase a property.

The other element to consider is that the party whose financing the transaction by purchasing it and then selling it to the final buyer, is taking on ownership risk. This is an important point. They actually own the asset over the period that it is being paid for and therefore take on the risk.

Now take a look at how banks are using similar financing. Rather than borrowing or lending at interest, they conduct the purchase or sale of an asset in which the proceeds are used as working capital. This is typically done with metals (copper for example). So a bank needing to cover $100m of working capital will do the following:

  1. Bank A needs $100m to cover working capital needs
  2. Bank A approaches bank B to borrow $100m
  3. Bank B will buy $100m of copper and sell it to Bank A for $105m
  4. Bank A agrees to pay $105m for this copper but will pay it later (i.e. in 5 working days)

Here a transaction is taking place using an actual asset rather than simply swapping money for more money.

But hold on.

Isn’t this just trickery? If Islamic bankers were magicians, then this is the equivalent of the “I've stolen your nose” trick. It doesn’t take a genius to realise that they’ve used their thumb instead.

The same thing is happening but we’ve just added this layer of “asset-transaction” to justify an interest rate.

I used to think like that initially when I first came across it.

But if a bunch of scholars are signing off on these transactions then surely there is some merit. These scholars have spent a number of years studying religion, jurisprudence (fiqh) and finance to come up with rulings and we should therefore not take their decision so lightly.

There are obvious flaws with this structure but we must take many things into account:

  1. Do the laws of the land permit an alternative that is tax-efficient - there’s no point of proposing an alternative that is highly taxed which renders the investment structure useless.
  2. Is this something that is practical and can be implemented?
  3. Will the costs not be too high?

I think the commodity murabaha is a necessary step in the right direction. Now is it used and abused? Of course.

Many are happy to stick to this structure and stamp on “shariah-compliant” badges on any of their investments because it’s familiar. It looks like a loan. It becomes easy to sell like a loan.

In this podcast, Harris mentions how more than 90% of Islamic banking is done using this same structure.

Unfortunately the Islamic banks haven’t innovated much. They’ve stuck to this form of financing as their main method of financing. It’s hard for them to do anything else.

The whole system is based on interest rates. The only thing they could do is replace this with commodity murabaha.

There needs to be a complete rethink of the system.

This is why I favour a bottoms-up approach.

Starting from the Bottom

What do I mean by a bottoms-up approach?

That the average investor, business person, has to find solutions and work their way up. They pave the way to let their actions affect the economy positively as a whole.

Why wait for the big banks to come up with funding solutions?

We believe in a free-market don’t we? We have the tools at our disposal.

I’m not saying it’s easy. But a few companies and individuals are trying to change things and making a dent in the industry.

Take Cordoba Capital Markets, Harris’ corporate finance boutique, for example.

A man who deserves much respect for tackling Islamic finance head on.

His book, Heaven’s Bankers, was an absolutely smashing read. It helped me put my life and career in perspective whilst learning about Islamic finance. 

This sector needs more people like him. Individuals who understand how capital markets and investment banking really work. They have practical experience and can challenge the Islamic finance status-quo that has been stuck in first gear.

Now do I advocate for future generations to become investment bankers so that they build up the necessary skills to make a real dent in Islamic finance? I’m not sure. A scholar would be in a better position to answer this but the more I think about it the more I see it as a necessary evil.

Anyways, let me go back to my point.

A recent article I found on LinkedIn referred to the issuance of profit-participatory notes (“PPN”).

This is an investment in which the investor gives money to a company and in return gets his money back plus a percentage of the profits made by the business.

Take an example of someone selling potatoes.

They need funding to pay farmers to grow, collect and package the potatoes.

Let’s assume they need $1m for this operation and they’ve calculated that after selling all the potatoes to the different distributors they will make a profit of $300k (after accounting for all the costs mentioned above).

The investor investing the $1m into the business can agree beforehand that they will want a portion of the profits. Let’s say 25%.

So with $1m, they will make a return of (25% * $300k=) $75k. A 7.5% return on investment. 

Now what happens if the profit was less? Instead of the initial prediction of $300k, only $100k profit is made.

In this case the investor’s profit will be reduced to (25% * $100k=) $25k. A return on investment of 2.5%. Likewise, should the business owner make a larger profit, the investor will see their return on investment increase.

The important thing to note is that the investor is taking risk alongside the businessman and they’re sharing the profits based on a pre-agreed percentage.

The profits come from the real economy from a real economic transaction. An actual good and service is being traded in return for a mark-up justified by the value-add (in this case the potatoes are taken from the farm to the consumer in the right package made easy for distribution).

When trading money for money,  or when commercialising lending, no real output is created. Only the supply of money increases whether that’s followed by an increase in output or not.

The reason why I like the PPN is because of its simplicity. The company can raise funds without diluting its stake in the business. Without giving any equity away.

This is an important point.

Companies are very sensitive to changes in their capital structure - i.e. a company’s mix of debt and equity. There’s advantages and disadvantages to either or.

Giving equity away is a great way to raise funds. You’re not liable to pay any investment back. You just promise a share of the dividends to equity holders. But that’s an issue in itself. You’re giving away profits and ownership of the business.

On the other hand, large and profitable companies will, most of the time, prefer using debt to finance capital expenditure. No ownership is given away. No profits are shared. The only cost is the interest on the debt they borrow.

You have to take into account the cost of debt and the cost of equity when making such a decision. But more often than not, very profitable companies will have a high cost of equity which makes debt more attractive as a means to raise funds.

If you, as a business, know very well that you can make a margin of around 80% from selling your goods or services, you’re going to prefer taking on debt and paying a fixed rate of 5-10% instead of tying the cost of capital to the percentage of profits made.

This is where Islamic finance puts the focus on fairness from both parties.

Not only should the owner of capital treat the recipient of investments (i.e. the company) fairly, but the company should also treat the investor fairly.

You can negotiate on the percentage of profits that will be shared. The important thing is that the return on investment is variable and tied to real economic output.

The benefit of the PPN is that the business owner does not have to give away any business decisions. They can be specific as to what profits are shared. They can share the profits from a specific venture, goods or service. Not the entire business itself.

The business owners can raise funding while keeping control of ownership. The investor puts their capital to good use and receives a percentage of the profits. Everyone’s happy.

The risk is evidently tied to the profits made by the venture. What if the items are sold at a much lower profit than anticipated? Or worse, sold at a loss?

That’s a risk the investor will have to bear.

Proper due diligence and investment analysis is required to determine the predictability of future cash flows.

A simple structure. Why haven’t we seen anything like this in Islamic finance before? There’s a number of reasons I guess. But most likely due to institutions being used to conventional financing. Why would you innovate if necessity isn’t there on a big enough scale?

In this case, the CFO of the business in question looking to raise funds, was actively looking for a truly shariah-compliant solution.

Much of the wealth in Muslim countries looking for shariah-compliant investments have been happy to accept questionable structures as long as they were certified.

In any case, Harris and his firm have managed to close the first deal and I’m keen to see the future deals they work on.

This is a perfect example of a bottoms-up approach. 

Someone was willing to come up with a solution for a business that was in need of a truly shariah-compliant investment. Without relying on anyone else.

It may seem easier said than done.

You have to structure it. Think of all the measures to put in place so that the investor is confident in the company executing on its strategy. You then have to market a new structure to investors. Not a piece of cake but if the risk-to-reward is attractive enough, investments will flow towards it.

How many Muslims investors are struggling to find rewarding and truly shariah-compliant investments? Cordoba Capital Markets has expanded this universe and inshaAllah we will see more solutions like these.

I’m excited for the future.

I have a few other ideas that can be implemented with a similar spirit.

All you need is a bit of financial ingenuity.

If you want to exchange ideas on particular structures that you’re thinking of putting in place and are shariah-compliant financing, let’s chat.


P.S. If you want to read more on commodity murabaha you can do so here and here.

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About Me

I manage a $100m private investment fund and I explore Islamic finance and economics through a personal lens. I help simplify financial markets from a Muslim perspective.

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