The $2 trillion market you’ve never heard of
Islamic finance is powering a new economy
Welcome back to MoneyLemma! Today’s post is about Islamic finance, which is a term for financial rules created in accordance with Sharia (Islam’s religious laws). Islamic finance is a big, growing part of the global markets and it does not get the attention it deserves. This point of this post is to explore an interesting asset class, not condone or condemn Sharia Law as an economic, moral, or political system
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Thinking different about investing
Recently I connected with Stefan and Wyatt, two smart guys who run Alts.
Here’s the idea: half the world’s wealth comes in the form of alternative assets. That covers a really, really wide range: the Mona Lisa, NFTs, fine wine, Air Jordans, collectible Lego sets, and every side hustle you can find on Tik-Tok. While it’s not hard to find a good writing on stock-picking or crypto, it is really hard to find good analysis on alternative assets.
That’s what Alts does. And they do it really well. So well that they’ve become the internet’s largest community for alternative investors.
I’d recommend this interesting article on franchises, which make up an amazing 3.5% of GDP (who knew). You should also check out their primer on investing in aged whiskey, because it sounds like something James Bond would retire into.
Alts was generous enough to make a donation to a Ukraine Crisis Relief fund in MoneyLemma’s name, which is why they are sponsored for this post - but I’d read their stuff even if they didn’t sponsor.
If you think today’s post on Islamic finance (a small slice of the alternative assets world) is interesting, then you should sign up for Alternative Assets and see what you've been missing.
The $2 trillion market you’ve never heard of
Imagine it’s 1960 and you’re a Vice President at a major US bank, doing whatever Vice Presidents do. Your colleague pitches a new idea: financial products like credit cards and mortgages that are interest-free. Let people borrow money without charging them for it! Naturally, you accuse him of being a Communist. No, he says, I’m a big-time Capitalist and you’re the Communist for accusing me. You call him a coward, the ultimate postwar-era insult, and the situation escalates to blows. At least, that’s how I would have guessed such a conversation would go. In reality, the 1960s and 1970s saw the birth of Islamic finance, or the application of Islam’s religious law (Sharia Law) to the capital markets. During this time global financial institutions, the most Capitalist of Capitalists, created financial tools that modernized banking for practicing Muslims, tools that defied the precepts of free market economics.
Islamic finance is a broad, fascinating topic that is far too complex for a single post, so this post covers one concept: Riba. Riba is the Sharia doctrine that bans interest (although there’s much more to it than that). Consider that the economy of the Western World is built on interest. Governments, by way of central banks, print and issue money by lending it out to banks who re-lend to everyone else at interest. Our global financial system without interest would be like One Tree Hill without Chad Michael Murray (it wouldn’t work). Money would rapidly become meaningless. Within days people would tribalize according to sport-team affiliations. Within weeks the world would look like The Hunger Games or Divergent or The Maze Runner (take your pick of 2000s young adult dystopian fiction). Interest isn’t just a tool in modern society, it’s the fulcrum upon which the global economy tilts and whirls. Yet banks all around the world have issued Islamic finance products that have removed interest from banking. And it works! Islamic finance is a $2 trillion market:
How does Islamic finance work?
Islamic financial products are alternatives to traditional financial products. Most people in the US use services like credit cards, home loans, auto loans, and savings bonds to meet their financial needs. All those products use interest. Islamic finance pioneers (mostly banks and governments) invented really cool ways to accomplish all the same things without interest. Here’s a few examples:
Murabahah is a popular alternative to debt. A business sells some of its assets (say, ownership of a house or the company car) to a bank and they agree to buy it back at a later date at a specified price.
Sukuk is another debt alternative (over $200 billion in existence as of 2014). Sukuk is best illustrated with an example. Normally McDonalds might borrow $1,000,000 at 5% interest, and later repay lenders $1,050,000. With a Sukuk certificate, McDonalds would borrow $1 million and lenders would receive all future profit from any Shamrock Shakes that McDonald’s sells. Over time, lenders will make their money back plus profit. This way, Sukuk is like a loan without interest.
With Musharakahm, companies borrow money from lenders. In exchange, lenders receive a special type of stock (ownership stake) that expires at a predetermined date. Lenders receive a share of the profit while the stock is active. Once again, lenders get repaid and make a profit - but never receive interest.
Ijarah is a creative use of accounting leases that help temporarily move money between parties (this one is a bit more technical).
Riba, Shmiba, so what?
You may be thinking that these financial products are neat, but don’t accomplish anything. At the end of the day one party is taking money and paying back more later. Sure, there’s technically no interest, but, effectively, there’s interest. What’s the difference?
The difference is in the governance, which is the system by which organizations and economic relationships operate. In this case, it’s all about incentives: a loan with interest means the borrower and the seller are incentivized differently. Season 2 of The Sopranos illustrates this dynamic: Davey Scatino becomes indebted to Tony Soprano and pays him back by handing over ownership of his sporting goods store. Tony, looking only to make back what he is owed, squeezes every penny out of the store and then leaves it bankrupt. Tony is incentivized by maximizing profit over the time period of a month or so. Davey had invested his whole life in the store and wanted to maximize profit over decades. There’s a clear conflict of interest, and it results in Tony completely ruining Davey’s life (Tony Soprano doesn’t lose conflicts). Here’s the full plotline, it’s amazing television if you’ve got ten minutes to spare:
One of the principles behind Riba is that, when it comes to debt, there’s an inherent conflict of interest. The lender is always incentivized to get their money back, while the borrower is always trying to maximize the returns of whatever they used the loan for. In the earlier example: McDonalds borrows $1,000,000 with interest in order to build a Shamrock Shake super-factory Over time, McDonalds stands to make tens of millions dollars off this investment. The maximum amount lenders can make is $1,050,000 (initial loan + interest). The lenders don’t care if the factory makes $100 million or $2 million; they get paid the same amount regardless. That’s a conflict of interest. Riba proponents argue that this conflict of interest consistently leads to bad outcomes. Lenders just want their money back ASAP and lendees want to keep investing for the future; a battle ensues. In such cases Riba proponents believe that the arrogant, powerful Tony Sopranos will inevitably exploit the weak, pitiful Davey Scatinos.
Caption: This is from Goodfellas, not Sopranos, but same idea
That’s why a key tenet of Islamic Finance is that any investment return must be accompanied by commensurate risk-taking. In other words, lenders need to have their incentives aligned with borrowers. That’s what an products like Sukuk accomplishes - by making lenders partake in the business they lend to, they become teammates with the borrowers. Incentives are aligned. Once again, the McDonald’s example. If McDonald’s borrows money using debt, that debt has to be repaid no matter what. If McDonald’s uses Sukuk then lenders only get repaid if the Shamrock Shake makes money (since they get a share of the profit). In this case, both McDonald’s and the people who lend McDonald’s are in the same boat: they only get paid if the food sells. That is incentive alignment. It’s important to note that nobody gets anything for free here. Lenders can expect to make a profit with conventional debt or Sukuk - it’s just a different way of getting to profit.
The interest problem and some interesting solutions
The view that interest is a flawed invention may seem crazy to someone steeped in 21st century Capitalism, but to most humans who ever lived in organized society it would seem natural. Interest was frowned upon by most major religions in the history of the world. Bhishma, of the Hindu epics, decreed “those who take exorbitant interest rates...have to sink in hell.” The Buddha seemed to agree, listing moneylending as a dishonest practice. Interest was flat out banned for a stretch in Ancient Rome, by the Catholic Church for much of the Middle Ages, and by Moses in the Old Testament. Even Jesus, normally a chill guy, pulled out a whip and lashed all the money-changers at Herod’s Temple. Over time these bans receded. Interest is a valuable mechanism for creating economic wealth because it creates an incentive (profit for lenders). Consider the Godfather: he’s not going to have any whacked unless he gets something in return:
In most of the world, this has meant an uneasy peace. Interest is fine, but usury, charging excessive interest, is not. Islamic finance has gone a totally different way and created some really interesting alternatives to interest. Do they actually succeed in fixing the flaws with interest? It’s hard to say. A widespread complaint is that many Islamic finance products don’t resolve the incentives issue, but just find loopholes. The Accounting and Auditing Organization for Islamic Financial Institutions (quite a mouthful) once claimed 85% of Sukuk is not actually Sharia-compliant. In other words a bunch of greedy bastards polished a turd of interest and called it a Sukuk diamond. Any bank can claim to offer a Sharia compliant financial products (and many banks do), but who is reading the fine print and making sure it honors the spirit of Sharia law?
Interested in using Islamic finance products?
These days, most financial products (bank accounts, credit cards, loans, etc.) have Islamic finance alternatives. Not all banks have created these alternatives so you’ll have to shop around. HalalWatchWorld lists some US-based lenders here.
Here are the sources for all those religious claims: Mahabharata Anusasana Parva Section XXIII, Pali Canon MN 117, Lex Genucia (340 BC), Catholic doctrine of contractum trinius, Exodus 22:25, Matthew 21:12–17, Mark 11:15–19, Luke 19:45–48, and John 2:13–16