The Middle East’s increasingly prominent role in the world of international finance has prompted questions about whether banking practices followed by both Islamic and Western institutions are in compliance with sharia, or Islamic law.

It’s an issue to which Hossein Askari, Iran professor of international business and international affairs at George Washington University, has devoted a lot of time. Wiley published Dr. Askari’s book Globalization and Islamic Finance: Convergence, Prospects, and Challenges in November, and it is publishing The Stability of Islamic Finance: Creating a Resilient Financial Environment for a Secure Future later this month. Dr. Askari’s book Islam and the Path to Human and Economic Development is scheduled to appear in coming months.

Dr. Askari explains that the three requirements for Muslim financiers articulated in the Qur’an are that Muslims must not borrow or lend money with interest, that all information in any contract must be revealed, and that, in order to bring parties together, business partners must share risk, so that both parties stand to gain or lose based on their investment. Risk sharing precludes a relationship where one party assumes all the risk, and the other reaps a profit even if the former investor does not turn a profit. These three rules apply regardless of the faith of the other party.

Although many banks declare their financial products “sharia compliant,” they are not offering a product that is truly based on sharia, stresses Dr. Askari. “What you see today isn’t Islamic finance,” he says. “Most of the banks do not have that risk-sharing component. Investors want a bond, and banks create something that looks like a bond but they say it is not a bond, so that it is sharia compliant.”

A bond is essentially a loan upon which the borrower agrees to pay interest. By offering sukuks (Islamic bond-like instruments) that exhibit bond-like behavior, which they declare are not bonds, banks have created an $822 billion market, according to a recent article in the Economist. According to Dr. Askari, sukuks make as much sense as transparent hijabs.

“A bond with a predetermined return is outlawed. That is what Islamic banking is all about,” says Dr. Askari. “Money cannot earn you money. Money must be invested in real projects, with the return uncertain.”

But Dr. Askari readily admits the sort of sharia-based banking he describes is not even being practiced in places like Saudi Arabia. “Do you think they deposit money without asking for interest?” he asks.

A CNBC anchor recently asked Dr. Askari how Dubai’s economy could be so troubled when it was supposed to be practicing risk sharing. The answer to Dr. Askari is that Dubai’s system was only sharia-style, but not sharia-based. The investors had no connection to the projects that they financed, and they thought that they were getting a fixed return and that there was no risk.

“Many Muslims have memorized the Qur’an, but they don’t know what it means for economic and financial dealings,” Dr. Askari says.

If Hossein has money to invest and he wants it to be compatible with Islamic teachings and does not want take risks, he might turn to a fancy New York bank that promises a 10 percent return each year, Dr. Askari explains. The bank does not call the return interest, because it must be sharia compliant. Instead, it solicits a stamp of approval from Islamic scholars it has placed on its board, who are often paid up to a few million dollars each year just for serving on a number of sharia boards, Dr. Askari says. Hossein leaves happy, believing that his investment is completely legal under Islam. It would trouble him to learn that the scholars often sit on boards of more than one bank, creating a conflict of interest.

In Dubai, all seemed well enough when the banks and the investors were making money and refusing to call interest by its true name. But when the economy collapsed, all of a sudden the investors asked to be bailed out. Dr. Askari sees tremendous irony in this request. If the investments were truly sharia based, the investors know that they collectively stand a chance to either make money or lose their investment.

The ensuing situation is very confusing, Dr. Askari says. “This is not truly based on the Qur’an or the life of the Prophet Muhammad, which is what Islam is all about.”

Additionally, Muslims are not supposed to do business with companies that do not follow sharia law, says Dr. Askari. For example, Muslims should not buy shares in a company like General Electric unless they know that GE has no connections to prohibited behaviors like drinking alcohol, gambling or prostitution. “What if GE has sold shares and has also borrowed money to finance its business operations and is paying interest?” Dr. Askari asks. “To be compliant, you cannot even invest in companies that are paying interest.”

Still, the sharia-board scholars found a solution. One day they announced that it is permissible to do business with a company if it finances less than a third of its capital needs with bonds. Soon the scholars changed their minds and raised the percentage to 50 percent, says Dr. Askari.

Though he calls much of today’s Islamic banking, as practiced, a “façade,” Dr. Askari thinks its basic theory could serve Western economies well.

Roughly 30 years ago, the financial sector generated about 15 percent of the corporate profits in the United States. Before the recent economic crash, that percentage had leapt to about 40 percent. The problem is that the financial sector does not produce anything tangible, according to Dr. Askari. “Imagine if our whole economic sector was finance,” he says. “None of us would eat.”

Whereas in the past banks were seen as an intermediary to channel money from savers to the best investments, the bulk of their business today is speculation — a field that is explicitly forbidden by the Qur’an. “Also, the Western fractional reserve banking system creates money out of thin air basically, with no connection to real economic activity,” says Dr. Askari.

One of the factors that has led to the current economic crisis is the “leveraging of the banking system,” in which investors deposit their money in a bank, and the bank lends 90 cents of the investor’s dollar to other institutions. “If you deposit one dollar, you create 10 dollars. The banks then securitize these loans, sell them, get cash and repeat the process,” says Dr. Askari. “Fractional reserve banking creates money and employs leveraging, which you cannot do in Islam.” Nor can you package loans as assets and sell them.

So how is all of this relevant to non-Muslims and to individuals who do not run banks? According to Dr. Askari, 2010 is unlikely to experience a sea change in the Western financial system. “I don’t think anyone is going to use the words ‘Islamic finance,'” he says. “I think we will see more discussion about whether we want to rely more on equity financing, namely risk sharing, rather than debt financing.”

In the past 20 years, economists have noticed trends in the international flow of capital have tended to favor equity flows (like buying stocks in foreign companies) over debt (lending money). Dr. Askari argues in his most recent book that a system of finance that relies more on equity is much more stable than one that relies on debt. Such a system cannot produce the exponential growth that is endemic to speculation, but it also does not produce collapses of such great magnitude.

A business strategy of investing in real projects rather than making money by lending can apply to individuals just as it does to banks.

But ultimately, for some like Dr. Askari, the Qur’an makes its recommendations for purer reasons than financial stability. “The Prophet didn’t talk about this because it was financially stable,” he says. “He said it brings people together. If I come into a project of yours, we have to work together. It builds trust. It brings mankind closer together.”
— This article first appeared in George Washington Today