The purpose of this article is to enlighten fellow Muslims that everything under the conventional banking may not be haram (strictly prohibited).

Introduction To Islamic Banking

Interest income and speculative trading of financial and other assets in any form and shape is strictly prohibited (haram) in Islam. Over the last 20 years of my banking/corporate finance career, many Muslims have asked me about the acceptability of current banking system in Islam. The intensity of such questions has increased in the last 10 years when I moved into Islamic banking.

Islamic Banking and Finance Is Conventional Banking Completely Haram?

There is a widespread misconception in innocent Muslim minds that everything related to banking within the conventional system is prohibited in Islam. This probably stems from a (a) lack of understanding and (b) genuine desire of common Muslims to stay away from even remotely prohibitive income. Since this assumption of blanket prohibition is erroneous, I wish to explain in as simple a language as possible that apart from dealing in interest and speculation (both categorically prohibited in Islam), there are many permissible (halal) functions that conventional banking institutions perform and make substantial profits from (For some top GCC banks, see box at the end).

In my view, Muslims may engage in such functions in the form of customers, employees, investors or advisers. Some of these functions are briefly explained below:

Asset Management

–       Mutual Funds (MFs)

Apart from interest income, banks derive a significant chunk of their revenue by managing multi billion dollar Mutual Funds. These funds are raised from public and invested in the equities (shares) of companies listed on stock markets through asset management arms of conventional banking institutions. Mutual Funds allocate their investment across fixed income securities (Income Funds), equities (Growth Funds) and a combination of both (Balanced Funds). Muslims need to stay away from both Income and Balanced Funds due to interest being their major source of income.

Since Islam prohibits certain products like liquor, gambling, pornography and conventional Banks that derive major income from interest, even within Growth Funds Muslims need to ensure that their portfolio consists of shari’ah compliant equities only. Over US$ eight trillion of equity funds are managed by various conventional financial institutions across the globe, which generate billions of dollars of income for them. This income does not seem to contradict with any shari’ah injunction provided Funds are not engaged in speculative trading.

–    Brokerage

Another increasingly significant line of income for conventional banks is brokerage services. All publicly listed equities can be traded on stock markets only through companies authorized by the capital market regulators e.g. SEBI in India, CMA in Saudi Arabia and SEC in the US. Such brokerage companies are owned by all major banks. Since banking institutions have large clientele with surplus capital, these clients prefer to trade in equities with their known banks.

For providing this service, banks charge certain percentage of fee on the volume e.g. 0.5% on actual buying or actual selling (not speculative buying/selling) shares. In bullish capital markets this stream of income runs in billions. This brokerage income received from equities trading appears to be completely acceptable from the Islamic perspective. Here also, brokerage subsidiaries of conventional banks must refrain from speculative trades and sectors in the “negative list” indicated above and below.

Investment Banking

–       Managing Public and Rights Offering

Primarily there are two sources of funding business projects (a) debt which consists of all kinds of fixed return structures (loans) and (b) equities which cover variable return securities compatible with Islamic principle of profit and loss sharing. Working on any aspect (banker, adviser, lawyer etc) of conventional debt is unacceptable in Islam. However, advising, structuring and distribution of new equities through Initial Public Offerings (IPOs) or capital increase through Rights Offering to existing shareholders of established companies is a lucrative business for banks and income derived from this perfectly meets shari’ah requirements.

This function is performed by both independent Investment Banks like Merrill Lynch, Goldman Sachs and Morgan Stanley and fully owned subsidiaries of commercial banks like Citibank, HSBC, NCB (in Saudi Arabia) and SBI (in India) etc. Banks receive fee from companies raising funds from the capital market in return for providing services including drafting of prospectus (containing business details), development of financial model, putting together the underwriting syndicate, printing and distribution of share application forms and liaison with capital market regulators – like SEC in the US, SEBI in India and CMA in Saudi Arabia – for meeting regulatory requirements.

–       Underwriting and Distribution

Another core function of Investment Banking which is closely linked to managing IPOs is the underwriting of equities. Business projects worth billions of dollars are dependent on companies’ ability to successfully raise funds from public (new shareholders) and/or existing shareholders. If companies fail in this endeavor, not only projects for which funds are being raised get adversely affected, capital market sentiments in general are negatively impacted too. Such a failure may strongly damage economies through depressed investor sentiments. In order to avoid such an eventuality, capital market regulators insist on fully underwritten offerings.

Banks conduct extensive due diligence to evaluate all aspects of risk before giving their commitment to underwrite an IPO or a Rights Offer. Banks (both conventional and Islamic) with strong balance sheets are approached by issuers of equities. Banks commit to distribute a fixed percentage of those shares to their client. If they fail to distribute, then they themselves buy the un-sold number of shares. In a bullish capital market with high level of IPO activity, this income is quite substantial for banks and acceptable from an Islamic perspective.

–       Receiving Bank for Public/Rights Offerings

For making large IPOs successful, companies target hundreds of thousands of investors across their target markets. To solicit share application forms from such a vast number of investors, large commercial banks with extensive network of branches are appointed as Receiving Banks. Their function includes helping potential investors fill application forms correctly, process them, collect cheques/payment from investors, transfer the collected funds in a designated account of the issuers on a regular basis, report to the share issuing company, the regulator and financial adviser about the aggregate collections on a regular basis. For performing this function, banks are paid usually a lump sum fee. Though this fee is insignificant in terms of the total income of banking organizations, yet appears to be perfectly legitimate from a shari’ah standpoint.

Corporate Advisory

–       Mergers & Acquisitions (M&A)

The consolidation of businesses and cross-border expansions gathered pace in late 1990s and early 2000s. This was led by cash-rich international companies acquiring companies in either new markets, manufacturing new products or developing new technologies. The function of bank subsidiaries advising on M&A include (a) identifying the hidden value in target companies for the acquirer, (b) developing a distinct business plan than the one being pursued by the present owner in order to realize greater value from the same business, (c) approaching and then negotiating appropriate price of the target company on behalf of the acquirer, (d) coordinating with legal advisers/regulators etc. and (e) if required, arranging funding for acquisition. Since the M&A fee is a function of deal sizes, bigger the acquisition, larger is the advisory income.

Some recent M&A transactions are running into tens of billions of dollars bringing in hundreds of millions of fee income for advising banks from each deal. In Technology, Media and Telecom (TMT) alone  In 2013 global M&A activity totaled $510.3 billion in 2013. This is an increase of 54.1% over 2012. Advising banks in these deals are said to have earned hundreds of million dollars in advisory fee in some deals. A significant chunk of the TMS business is permissible. Similarly, M&A in the Oil & Gas sector touched US$ 136 billion in 2013. If the acquisition in these businesses happens through share/cash swap then the M&A fees income seems permissible in Islam.

–        Privatization of State Owned Enterprises

A vast majority of Muslim population resides in countries where governments have historically owned large business enterprises particularly in utilities and infrastructure sectors. With globalization, such state owned monopolies are facing increased competition from large international private sector players. To enhance efficiencies and profitability, these state owned enterprises need large capital infusion for upgrading technologies and improving management practices.  This capital requirement has triggered large scale privatization programs in various developing economies. Many large international banks possess financial engineering skills and global network required to restructure these entities and find private investors for them. This service comes at a hefty fee which appears to be in line with shari’ah requirements.

Private Equity (PE)/Venture Capital (VC)

The difference between PE and VC is of technical nature and is beyond the scope of this piece. For a common person, both are virtually same. This business is similar to Mutual Funds (MFs) described above. The major difference is that VC and PE investors as specialized subsidiaries of large conventional banks (there are many independent PEs and VCs too) raise funds from institutional investors like pension funds, endowments and insurance companies instead of public (though lately VCs are going public as well).

After raising funds, they usually invest in privately held companies (not listed on stock markets) while MFs raise funds from retail investors and invest in publicly listed equities. Apart from charging fixed annual fee, VCs/PEs also take ‘carried interest’ for taking higher risk (of investing in private companies) than MFs. This carried interest is a share in profit after returning back to investors all costs related to managing funds (fee etc.) plus a pre-agreed threshold return on investment. The net profit called ‘carried interest’ is usually shared in the ratio of 85:15 between original investors i.e. pension funds, insurance companies etc. called general partners and VC/PE fund managers called limited partners. Close to US$ 300 billion were raised globally in 2013, resulting in substantial fees income for the PE/VC fund managers.

This business has a negative correlation with a booming stock market i.e. in a bearish (declining) stock market, VCs/PEs get more opportunities to invest in equities of privately held companies  due to difficulties these companies face in raising money from the public market. In return, PEs and VCs earn substantial amount of money through a combination of fee income and carried interest. Both these income streams appear to be fully in compliance with shari’ah as long as the portfolio of investee companies is consistent with Islamically permitted structures (equities or Islamically structured bonds convertible into equities) and permissible businesses (free from alcohol, pork, gambling, interest, tobacco etc).

2013 in US$ Million

NBK

NBAD

QNB

SBI

ICICI

Net Interest Income

1,375.0

1,689.3

3,212.0

8,160.0

2,311.1

Net Non-Interest Income

846.0

869.7

802.3

2,950.0

1,391.0

Percent of Net Non- Interest Income to Net Total Income

38.1%

34.0%

20.0%

26.6% 

37.6%

NBK = National Bank of Kuwait; NBAD = National Bank of Abu Dhabi; QNB = Qatar National Bank; SBI = State Bank of India; ICICI = ICICI Bank

Bottom-line

This article is based on my limited religious knowledge of Islam and limited professional knowledge of banking. This list of halal (permissible) income streams within the conventional banking system is only indicative. It is impossible to discuss an exhaustive list of 21st century banking services within this article. Other permissible areas that do not seem to breach shari’ah injunctions include Custodial and Agency Services, Leasing (Operating) and specialized advisory services. The purpose of this article is to enlighten fellow Muslims that everything under the conventional banking may not be haram (strictly prohibited).

By Mansoor Durrani

Also See:
Debt Terrorism
rophet Muhammad : The Economist

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