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Islamic Banks Unhurt By Toxic Assets, But Could Suffer As Crisis Evolves

Banknotes are counted at Lebanon's Central Bank in Beirut, which in the early going has managed to steer clear of much of the fallout from the global financial crisis.
Banknotes are counted at Lebanon's Central Bank in Beirut, which in the early going has managed to steer clear of much of the fallout from the global financial crisis.
Political and business leaders at the World Islamic Economic Forum in Jakarta this week have been praising the prudence of Islamic financial institutions.

They say Islamic banks have not been hit by the global financial crisis as hard as their Western counterparts because they refrained from investing in toxic assets that were deemed "un-Islamic."

Indonesian President Susilo Bambang Yudhoyono says the financial crisis has proved the strength of Islamic methods of banking and finance. He says Western bankers have a lot to learn from Islamic finance, and he is calling on Islamic banks to take more of a leadership role in the global economy.

The focus on the Koran's prohibitions arguably make it difficult for Islamic financial institutions to work in the same way as a conventional Western bank.

For example, Islamic law prohibits investment in businesses that sell alcohol or pork, or that are involved in gambling. That means an Islamic banker must ensure clients that their deposits are not being reinvested in a firm that does business deemed as "un-Islamic."

Another basic rule of Islamic finance is a prohibition against what the Koran calls "riba" -- a word interpreted as the payment and collection of interest on loans or savings deposits. Under Islamic law, transactions must be backed by real assets -- tangible, physical assets such as gold, land, or equipment.

Abdul Gafoor, a Netherlands-based author on Islamic finance, tells RFE/RL that these Sharia-compliant rules prohibited Islamic bankers from dealing in second-hand interest-bearing mortgages -- the financial assets at the root of the U.S. subprime property market crisis which pushed the world into economic crisis. But it didn't prohibit them from investing directly in real estate, which has been losing value in many countries since last year.

"[Islamic banks] go mostly for real estate and that kind of thing. And when real estate prices go down, [their portfolios] also go down," Gafoor says. "It depends on whether they invested directly in real estate or through securities. Here, you cannot make a general claim [about the strength of Islamic banking]. It depends on each individual bank -- how they behaved."

Still A Wide Spectrum

In fact, there isn't a fixed set of rules that governs Islamic banking. Like Shari'a law, it's subject to interpretation.

Some conservative Islamic scholars have concluded that investing in stock markets is a form of gambling -- and is therefore prohibited by the Koran. But others interpret the Koran to mean that they shouldn't get involved in day trading -- the practice of buying shares one day with the intention of selling that equity soon after for a profit. Those Islamic bankers have invested in equity.

"The thing about Islamic banking, at the end of the day, in some respects, it is going back to banking the way it used to be done," Neil Miller, a prominent Islamic finance expert and partner at the Norton Rose international law firm in London, says. "So it is very much based on relationships, on analyzing risks, and understanding the risk and the relationships in the specific projects or company that you are looking to finance and getting comfortable with that. People need to go back to fundamentals."

But Miller also warns that being an Islamic bank is not enough to guarantee immunity in the long run from the financial crisis. He tells RFE/RL that some Islamic banks still could be hurt as the impact of the crisis spreads across the globe -- sending land and equity prices tumbling.

"Islamic banks have certainly avoided the worst excesses of the toxic-asset problem because they were certain asset classes that they could never have invested in. So in that regard, they have been insulated," Miller says. "As the crisis has developed and turned into a credit crunch, I think you have to start looking at Islamic banks in different countries and different parts of the world."

Risk Aversion?

Miller says that in some places, such Islamic institutions are better insulated against adverse affects from the current troubles.

"It really depends on exactly what their current asset component is," Miller says. "Many of the Islamic banks hold high levels of real estate and high levels of private equity. So although they have not been badly hit with bad debt through lending, which they can't do, they have been hit by asset valuations -- as some of their portfolios are perhaps not as robust as they had been in previous years."

Duncan MacKenzie, director of economics at International Financial Services in London, says there are other aspects of Islamic finance that have helped Islamic banks fare better as the economic crisis evolved into a credit crunch -- the drying up of credit that has made it more difficult for anyone, including banks, to obtain short term loans.

Experts point out that Islamic banks tend to lean more heavily on deposits, since they can't fund themselves on the interbank market that sustains conventional banks.

Senior analyst Firas Abi Ali, from the Islamic Financial Information Service, agrees that Islamic banks generally are better placed to handle the credit crunch. He also says the turbulence and uncertainty in the conventional banking system is now prompting some non-Muslims to consider the option of Islamic banking.

Former Soviet republics in Central Asia also have been taking steps to create a legal framework for Islamic financial institutions.

In February, Kazakhstan's Nursultan Nazarbaev signed amendments into law that are expected to help establish Islamic banking in the country. Kyrgyzstan's parliament last month also approved amendments on the introduction of Islamic financial principles into the country's banking system.

But critics say there are other issues that should make potential investors do their research before investing money in an Islamic bank.

Some say that Islamic finance has become so intertwined with the global financial system that problems in the future are unavoidable -- especially as prices tumble for assets like real estate. Gafoor concludes that there is no real data available to check the claim that Islamic banks are largely protected from the global financial crisis.

The balance sheets being made available to the public by some major Islamic banks are unaudited, which raises questions about the real extent of their exposure to the crisis -- even if their investments are deemed Shari'a-compliant.