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Over the last several decades, governments have collectively pledged to slow global warming. But despite intensified diplomacy, the world is already facing the consequences of climate…
Ali: Islamic Banking is a Rapidly Growing Industry
Jawad I. Ali, a lawyer who helps corporations structure sharia-compliant finance deals, discusses the boom in Islamic banking and the industry’s future.
June 7, 2007 10:38 am (EST)
- Interview
- To help readers better understand the nuances of foreign policy, CFR staff writers and Consulting Editor Bernard Gwertzman conduct in-depth interviews with a wide range of international experts, as well as newsmakers.
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Can you explain what sharia finance is?
Sharia-compliant financing is done by investors who chose to invest their money in a manner that is compliant with Islamic sharia. The basic principle of investing on a sharia-compliant basis is that when you are introducing any leverage, any financing, that leverage has to be compliant. This means you cannot receive or pay interest on borrowed money. In conventional finance, there is a distinction between usury and interest. Regulators in the United States and western jurisdictions regulate and distinguish between interest rates that are considered reasonable and interest rates that are considered usurious. Under Islamic sharia, any interest—even 0.01 percent—is usurious. There is no distinction between acceptable interest and unacceptable interest. So if you are financing a sharia-compliant investor, you have to figure a way to inject that financing other than borrowing and charging interest.
How does that work?
One of the tools is leasing. In a real estate context, usually a borrower would go to a bank and say, “I want to buy this building, the building costs one hundred dollars and I have thirty dollars, I would like you to lend me seventy dollars.” There would be a loan agreement and you would pay interest on the seventy dollars that you borrowed. In a sharia-compliant context, instead of borrowing the money, you can structure the transaction so that the bank, or a bank-controlled entity, acquires the property and leases it to the sharia-compliant investor. Rather than the sharia-compliant investor paying interest, he pays rent. The rent is perfectly acceptable because the creditor has taken the risk of ownership rather than just granting money. You have taken ownership of the asset, which has certain risks associated with it, and you are charging rent to the end user.
Given the extra step there, is it an inefficient process? Is it more expensive for businesses to have to go through this process?
In the United States, structured finance and leverage leasing are recognized and have been done for tax reasons apart from sharia-compliant reasons. It is an extra step—the borrower is not going to the bank and saying “Ok, I already have the thirty dollars, you gave me the seventy dollars, and I will mortgage the asset in your favor.” Here, we have an extra layer. Usually because banks cannot own real estate, you will have to have an entity that is owned by a corporate services company or a trust, borrowing conventionally and then turning around and using the proceeds to finance the acquisition for the sharia-compliant entity by way of a financial lease which is coupled with a call option [which gives the buyer the right but not the obligation to buy an asset]. So the sharia-compliant investor is not only leasing the property, but also has a call option over the asset.
Putting aside the requirements of a sharia-compliant investor, a lot of U.S. multinationals use leasing for tax reasons. The banks do understand that some borrowers just prefer to finance the acquisition of an asset for tax reasons, or for sharia reasons, not through the conventional methods of just borrowing, but through a structured finance deal.
Besides the compliance requirement against interest, are there other major requirements businesses have to meet?
Besides the prohibition on the payment and the receipt of interest, the activity being financed has to be compliant itself. If we are talking about real estate, the activities undertaken on the property have to be compliant. The tenants have to be compliant. They can’t be conventional banks, or insurance companies, or businesses that trade in pork products, firearms, or any immoral activity. You can’t have a gentleman’s club on the premises. You can’t have a liquor store, because in Islam there is total prohibition on any alcohol. If you’re buying a company, the activity of that company has to be compliant. If you are acquiring a controlling interest in that business—and a controlling interest here means anything above 33 percent—then all the finances in that company have to be compliant. If you are acquiring a minority stake then they allow the debt-to-equity ratio to be 33 percent. This means the total debt in that company cannot exceed 33 percent of the amount paid in capital.
Caribou Coffee is one of the biggest American firms that runs according to sharia business practices. Its parent company is owned, in part, by the government of Bahrain. What are some of the other big companies that are now sharia compliant? Are they mainly privately owned or state owned?
I’m not aware of the exact shareholding of Caribou, but the government of Bahrain is not in fact sharia compliant and they have conventional debt in place. So it’s not a government-driven industry. On the contrary, it’s very much driven by investors and institutional investors who choose to invest on a sharia-compliant basis. Sharia-compliant investments are more akin to ethical investments. There are conventional ethical funds that define a certain investment strategy that they adhere to, and the growth in the industry has really been driven by the pension funds in the GCC countries. One can argue that these pension funds are administered by the state. But the majority of the industry is really driven by individual investor families and the investment offices of these families who choose to invest on a sharia-compliant basis.
There’s a fairly broad consensus that the sharia finance industry is growing. What kind of growth are we talking about? Do you have numbers on that?
When King & Spalding started working on sharia-compliant transactions in the early 1990s, a lot of people thought this was a fad and that we would do one, two, maybe three transactions a year if we were lucky, and maybe have some repeat business from those same clients. Just to show you the growth that we have at King & Spalding, from that moment in time until today, we now have four partners and twelve associates, supported by 250 lawyers booking time to sharia-compliant transactions.
Do you have any dollar estimates for the size of the global industry?
Because most of these are placed privately, I don’t know, but I’ve heard estimates that put it in the $100 billion to $150 billion range. I’ve heard estimates that are higher than this, so it’s definitely a very growing enterprise. The only sure thing is that the industry is growing by about 35 percent to 40 percent on an annual basis. I can attest to that because we can see that internally in King & Spalding.
Is this just due to there being more money and families interested? Has there been a theological shift? What’s causing this growth?
There are three factors contributing to the shift. First, in the beginning, even the sharia-compliant investors used to steer away from leverage. If they chose to invest in the United States, either in property or in a company, they used to bring equity. If the company was worth $100 million, they would raise $100 million and bring it over to the United States and buy the company. They felt you could not really effect sharia-compliant financing.
As the industry developed, and people like King & Spalding got into it, we came up with structures that are not only sharia compliant but are tax efficient and enforceable within the jurisdiction where the transaction is being undertaken. The investors started to say, “Well, it is possible, I don’t really have to kill my return by just using equity funds, and I can really seek to leverage my investment and benefit and enhance my IRR [internal rate of return].” That was the first push for the growth in the industry, when people became aware that it is possible to do it and it is not as costly as people thought. It’s just another form of structured finance.
Lastly, and most importantly, the high liquidity in the Gulf Cooperation Council (GCC) countries—Saudi Arabia, Kuwait, Qatar, Bahrain, Oman, and the United Arab Emirates—that is driven by the high prices of oil has trickled down in the last three or four years. As a result, the economy is booming. It has always been central to the Gulf-based investor groups to diversify, so it was natural for them to tap into the United States. When the United States became too expensive in the real estate and private equity markets, they moved over to Europe. Now we’re seeing a boom in sharia-compliant investments coming to Europe. We’re also seeing a shift toward regional investments in the Far East.
Where do you see the saturation point for the market? Is there a whole lot more growth potential? What do you anticipate in companies and investment funds outside the Middle East, in Europe and the United States?
I suspect there will be a lot more. The industry is now reaching a very high level of sophistication. If you look only five years ago, you’d only find a handful of investment banks focused on this investor type. Now you have Citigroup, Deutsche Bank, HSBC, Lehman Brothers—mainstream investment banks have windows or divisions that focus on structuring sharia-compliant investments. Besides that, the innovation is really driven by boutique investment banks in the Middle East whose whole mandate is to be sharia compliant. I’d also credit Arcapita Bank, out of Bahrain, for structuring numerous sharia-compliant transactions in the United States, investing in both private equity and real estate. You have players like ABC [Arab Banking Corporation] and Kuwaiti investors like Kuwait Finance House who have been at the forefront of structuring sharia-compliant investment funds—whether it’s in real estate or private equity—and placing those funds in the Middle East with sharia-compliant investors.
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