Regulation and Risk Sharing in Islamic Finance
I am contemplating a law review article, probably for March distribution, that centers itself around the following regulatory irony in Islamic finance.
Ask your average proponent of Islamic finance what it is about the practice that makes it conceptually distinctive from conventional finance, the answer is, invariably “profit sharing” or at times “risk sharing.” That is, when the Islamic bank engages in a murabaha transaction with a homeowner, it buys the house and sells it to the homeowner at a higher price. It is true that the markup reflects the prevailing interest rate, in fact it can be pegged to that rate. However, the home was owned by the bank and then sold to the homeowner, a purchase and sale of an asset was involved, and hence the transaction was fundamentally different. Some would say the mere formal process of purchase and sale was sufficient to make it different (that is how I read Frank Vogel’s work), but most proponents go further and say that it isn’t the mere formality, but also the fact that the bank took a risk, no matter how small, and but for this risk, there is no shari’a compliance. Certainly Usmani says this in his work Introduction to Islamic Finance. (I should note some say the profit must be commensurate with the risk taken to be compliant with Islamic finance, but I find this position so at odds with the realities of the practice, so absurdly fantastical as an expression of anything resembling actual human experience that is best discarded. Nevertheless, you find it in the books, and when you do, your eyes should roll.)
So far, so good. Or not really perhaps, as I’ve pointed out the risk is more hypothetical than real in huge numbers of sharia compliant transactions, but let’s not go there, let’s take this at its word, the transaction, we will posit for argument’s sake, is different because the bank takes a supposed and alleged risk by virtue of ownership.
Here’s the problem. Banks in the United States (really in keeping with banking everywhere, but I want to focus on the US regulatory environment) are not permitted to own real estate. They can lend money to someone else to enable them to own real estate (i.e. a mortgage) but the ownership of real property actually is risky and precisely the type of speculative investment we don’t want banks to make as the potential for loss becomes all too real, and the federal government backs those institutions.
Yet the Office of the Comptroller of the Currency does not want to prohibit Islamic finance, or regulate it out of existence, it’s a practice after all with real commercial value and it isn’t particularly harmful, except to the extent that mimicking conventional finance techniques and clothing them in Islamic garb is per se problematic. So the OCC in the US permits the murabaha transaction, precisely because it’s not really a risk of land ownership the bank is taking on, it’s just a formal hoop to jump through. In fact, let’s be more specific, the OCC permits the murabaha as a banking transaction on condition that both the risk of payment default and the risk by virtue of land ownership are zero, or more precisely stated are exactly what they would be for a conventional loan. In other words, Usmani’s distinction, that of additional risk by virtue of ownership cannot exist for a chartered bank to engage in the murabaha. It’s all there in the interpretive letter.
That’s the risk on the portfolio side. What about the depositor side, where again the argument is the relationship is that of a mudaraba, or silent partnership, where depositor and bank share in profits and losses? Again, it’s not actually what happens, but let’s go along with the proponents of Islamic finance and assume the possibility of a hypothetical loss, however small that possibility might be. Again, a problem, because depositors cannot lose money in bank deposits, again by regulation (they are federally insured remember), and so the hypothetical loss may not exist. So you have to guarantee the deposits against loss. As a result, upstream and downstream, for investment and depositor, the risk profile has to match conventional finance exactly, or the bank cannot be licensed. Profit sharing and risk sharing is not only a practice that is merely hypothetical in conception, it is also a violation of core regulatory practice.
You can see the tension, as between what regulation requires, and what Islamic finance demands of itself as core justificatory commitment. It’s worth exploring, and to see it explored, hang around and I’ll pull something together soon enough.