Now extend that principle to more complex transactions, and you have the basis for commercial Islamic finance. Corporate or sovereign bonds get around the prohibition of interest by being structured as ownership interests in the underlying asset, entitled to a proportionate share of the returns generated by the asset. (A secondary market in these bonds, called sukuk, has already come into being in the Middle East.) Even private equity can operate in an Islamic context. Under the terms of a typical deal, a company being invested in could be viewed as a series of assets leased to the private equity fund, which would eventually control the entire business. The return to the fund would be based primarily on the company’s growth.
Such strategies are evidence of the increasing demand on the part of Islamic investors for innovative sharia-backed products, attributable in part to the huge supply of petrodollars flowing into the coffers of the Middle East and Southeast Asia thanks to record-high oil prices. Some of that money has been absorbed by mammoth construction sprees in such fast-growing cities as Dubai, in the UAE, and Doha, in Qatar. But a great deal of the cash still needs to be put to work, diversifying portfolios and, to the degree that Muslims can, hedging against risk. So Middle East investors are seeking investments outside the region, in places such as the U.S., Europe, China, and India, increasingly through sharia-compliant deals. That explains the emergence of firms such as Arcapita Bank. Founded in 1997 by a group of Middle East financiers, the bank, based both in Bahrain and in Atlanta, Ga., makes sharia-compliant investments in private equity, ventures, real estate, and other vehicles, primarily in the United States. Since its inception, Arcapita has made a total of $21 billion in investments.
Arcapita wasn’t the only early innovator in this market; numerous multinational banks have set up sharia-based investment groups in Muslim countries. For instance, Citigroup Inc. was one of the first Western banks to enter the Islamic finance arena, incorporating its Citi Islamic Investment Bank in Bahrain in 1996 to conduct a variety of banking operations, including trade finance, fund management, and Islamic securities. The bank also runs an equity fund that invests only in sharia-compliant companies. And in October 2005, Citigroup joined with Dow Jones & Company to launch the Dow Jones Citigroup Sukuk Index.
Citigroup, however, is one of the very few U.S.-based banks committed to this business; most of the Islamic finance activity by non-Muslim banks is taking place in Europe, where such giants as Deutsche Bank AG, ABN Amro Holding NV, Société Générale, and HSBC are heavily committed. The next step in answering the call for sharia-compliant investment vehicles involves offering even more exotic instruments than mortgages, capital loans, and bonds. Already a variety of banks based in Muslim countries have introduced sharia-compliant hedge funds, and several Western banks, including Barclays PLC and Deutsche Bank, are on the verge of doing so.
Given the intensifying demand among Islamic investors for sharia-compliant finance in all forms, more U.S. financial institutions must accept the growing importance of Islamic finance. In the process, they may discover that some of the innovations that make banking palatable in the Middle East can also be of dramatic benefit for their non-Muslim customers.
Edward Baker, former editor of CIO Insight magazine, is a contributing editor at strategy+business.