How Modern and Islamic Finance can Coexist in Egypt
Integrating Islamic Finance
Modern and Islamic finance are not mutually exclusive and need not be at odds. They can coexist in Egypt, with the former dominant and worthy elements of the latter integrated into mainstream finance.
Egypt’s economy needs to grow at around 6% yearly to provide good, well-paying jobs for the 700,000 yearly entrants to its 29 million-strong labor force; both challenging targets that have rarely been met in the country’s modern history. Achieving and sustaining such strong growth requires a large, strong, vibrant and well-funded financial sector. In Egypt as in many other Muslim countries, though, funding, development and performance of the modern financial sector, specifically its banks, bond market, insurance firms and home mortgage lending, are undermined by traditionalist Muslim clerics and Islamist politicians, who ideologically reject the time value of money, campaign against modern, interest rate-based finance as Islamically illegal, and advocate the alternative, interest rate-free “Islamic finance”, which has rapidly grown over the past 40–50 years to nearly USD 3 Trillion worldwide now, continues to grow fast, has many adherents and cannot be ignored. Islamic banking accounts for USD 22 Billion, or 6% of Egypt’s USD 370 Billion in bank deposits. The two alternatives need to coexist to serve the national interest, and it is now time to reconcile the opposing views and reach a consensus compromise that is mutually acceptable and beneficial.
Modern finance has proven itself the fairest and most efficient way to allocate and employ capital. Still, two elements of Islamic finance, outlined below, are worthy additions to the system. Modern finance complies with the true principles of Islam, which banned the harsh, extortionist practices of Riba (usury) of that time, when money lenders exploited the dire financial straits of their desperate clients by unscrupulously charging exorbitant and ruinous interest rates. It is this sky-high interest extortion that Islam forbade, and not interest per se. In modern banking, the depositor, bank, business borrower and national economy all gain, with no riba-type extortion involved. Islamic finance is doing well in Turkey, Arabian Gulf countries and especially Malaysia, where it is well-established.
Regarding the needed compromise, banks need to offer the Islamic financial instruments of “Musharaka” (joint venture) and “Mudaraba” (profit-sharing), so as to attract significantly more deposits and loan requests from religious-minded depositors and businesses, respectively, and engage in Islamic law (“sharia”)-compliant activities, which include bans on activities such as those involving alcohol, gambling, pork and others. In return, Egypt’s religious establishment must support modern finance and publicly accept it as Islam-compliant. The Egyptian economy needs to be firing on all cylinders, with a healthy financial sector enjoying wide public participation, unhindered by ideological infighting that is especially harmful to modern finance. Islamic finance, being newer and on shakier legal and theoretical ground, needs support, coupled with regulating and curbing its murkier, riskier and potentially harmful elements.
While the banking sector needs to adapt and broaden its base to include Islamic finance, it should be understood that their primary dealings with depositors and borrowers will continue to be through interest-based transactions, whose advantages include clarity and lower costs and risks to the banks and their depositors. In accordance with financial standards, interest claims receive higher priority than taxes and shareholders’ dividends. The general financial rule is that if you seek higher return then you must accept and be willing to tolerate higher risk. With modern finance, the borrower is obligated to pay the interest in full. While the interest income is fixed, even in profitable years, the security of this arrangement generally suits elderly, less well-off and generally risk-averse depositors.
Islamic finance is generally higher in both risk and potential return, and this must be made clear to participant depositors and borrowers. It has also evolved in recent decades to mimic modern finance with a lag, and tends to be higher in costs and legally murkier. Many Islamic finance instruments are dubious or fancy versions of modern finance, but under Musharaka (joint venture), the bank uses the depositors’ money to buy direct equity stakes in the borrowers’ company. The higher risk is due to the fact that, unlike guaranteed cash deposit rates, in a bad year the depositors gains nothing and might even lose money. The potential for higher return is due to that, in a profitable year, both he/she and the bank get pre-determined shares of the net income after taxes. This arrangement mostly suits younger, better-funded, intrepid or anti-interest leaning depositors. However, it would be more prudent for banks to impose age and deposit-to-income restrictions, while depositors and businesses alike must fully understand and officially agree to the higher risks. Islamic finance must also be subject to strict oversight by the Central Bank and Ministry of Finance.
Mudaraba (profit-sharing) is an interesting system for financing business projects. If the bank’s cash flow and risk analyses indicate a profitable and creditworthy project, then credit is extended. The norm for most ventures is that expenditures are high in the project’s early stages, while the bulk of the revenue and profit follows later on. Instead of fixed interest payments, though, the bank waits for the project’s cash flow to start generating net, after-tax income. A pre-determined share of that profit goes to the bank, and another to the depositor. It must be stressed that here too the risk/reward profile is higher than in classic project financing. Banks would have to be very selective as to which projects they finance that way, and the credit analysis has to be top-notch. Banks need to be required by law to use only funds by depositors who specifically allocate their money to Mudaraba, and who fully understand and officially accept its higher risk. To lower risks, mudaraba would only cover a minority of banks’ financing activities.
Primacy of Modern Finance
Prominent among non-bank finance is the market for government and corporate bonds. An individual or organization buys bonds in cash issued by government and large corporations in return for a fixed, flat interest rate for the duration of the bond, and the the invested amount paid back when the bond matures. Here too, it must be made crystal-clear that this interest is Islam-compliant. The government and corporations are certainly not being exploited here either, as this investment tool provides them with cash to use at their discretion. Further advantages exist. Issuing firms are only required to pay fixed interest, so profits and distributed dividends are not diluted over a wide base of shareholders. Government bonds are also effective and practical, and allow creation of a secondary government bond market, where individual and corporate investors can trade government bonds and treasury securities, safeguarding against the risk of the government competing with, and crowding out the private sector over access to bank credit. For individual investors, bonds and treasury bills are a low-risk and reliable source of interest income. As such, they are quite suitable for various types of risk-averse investors. Egypt needs a secondary government bond market, and its existing markets need policy support with the aim of making them deeper and more liquid.
The premise of insurance, whether on life, health or property, has been criticized, by the same opponents of modern finance, as un-Islamic. Critics emphasize that Islam teaches Muslims to go along in their lives, engage in risky ventures as they see fit, and put their trust in God and accept any adversity as His divine will. Critics reject insurance as breach of these principles. However, Islam also teaches prudence, principled pragmatism, and the taking of sensible, concrete precautions when embarking on risky behavior and ventures. These two virtuous principles are mutually compatible, and are of great benefit when combined in individuals and in society as a whole. It is noteworthy that Christianity teaches a similar combination of faith and trust in God coupled with prudence and principled pragmatism.
Risk, and adverse events such as fire, robbery, natural disasters such as flooding or earthquakes, accidents, the sudden illness and death of individuals, are facts of life and do occur, sometimes causing great harm to humans, businesses and communities. Insurance enhances security, shares the burden and softens the blows that inevitably occur. As a practice that serves individuals and communities and in compliance with Islamic principles, insurance deserves to be publicly, clearly and unequivocally recognized as Islam-compliant. Insurance protects individuals, families, communities and businesses. It also protects against large-scale economic disruptions, rewards and encourages controlled risk, especially small business owners. Many of them would otherwise not be in business.
Home ownership via mortgage loans is long-established in all advanced and many developing economies, where it is the norm in much of the former. Under this system, the buyer applies for a mortgage loan from his/her bank. If a credit check verifies that the applicant is creditworthy, the bank extends the loan by buying the house and allowing the borrower to move into it. The house becomes the loan collateral. Based on the house’s price, the buyer pays a share of the price as a down payment, and makes monthly payments towards repaying the principal loan amount plus a pre-determined interest. The number of years and the rate of interest are determined according to market demand and supply, and are subject to strict government regulations.
The mortgage system offers great advantages, but entails risks. It allows much wider home ownership and provides profitable business and interest income to the banks. Real estate construction and employment would get a substantial boost as a result of the arising business opportunities. The risks are substantial, though. If a home owner loses his/her job, the monthly mortgage payments may become unaffordable, leading to higher loan default risk. Another risk is that if banking sector regulations are too lenient, the banks would extend too many mortgage loans to applicants with insufficient creditworthiness, as did many US banks in 2004–07. In Egypt, the top religious officials have reluctantly approved introducing the mortgage system to Egypt, and it remains controversial. To its opponents, the prospect of borrowers facing unaffordable interest payments to their banks smacks of the extortion and exploitation that define riba (usury). In the particular case of mortgage lending, these concerns are valid and must be thoroughly assessed, addressed and resolved by consensus for the nascent mortgage market to thrive in Egypt.
Fortunately, there are valid arguments in favor of mortgage lending, and strict policy regulations and precautions that allow it to be offered justly, safely (and Islamic law-compliant) for middle-income buyers earning USD 625–1,900/month. Mortgage loans are not for everyone, being too risky a commitment for lower-income buyers, while higher-income buyers do not merit financial support, and can pay in cash or installment plans, as is now done. Exclusion of lower-income buyers is meant to protect them, as they are very vulnerable to economic and social shocks, given the lack of mortgage insurance and the insufficient nationwide social safety nets in Egypt, such as jobless benefits, retirement pensions, health, and life/disability insurance. Exclusion of buyers of pricier apartments, villas and comparable homes aims at social justice and avoiding institutional bias in their favor against middle-income ones.
Most importantly, responsible clients would be well-protected. Long loan maturities and reasonable interest rates would boost loan affordability and availability. The loan-to-income ratio requirement, mortgage insurance and four universal social safety nets recommended would cushion virtually all non-fraudulent clients against financial shocks and default risks. With only creditworthy clients receiving loans, a healthy and growing mortgage market would result. As such, mortgage lending would be free of the ethical prohibitions that would make it un-Islamic, it would gain acceptance and thrive. Compromise, coexistence and harmony between modern and Islamic finance would greatly serve Egypt.
