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The Increasing Role & Potential of Islamic Finance in Afghanistan

March 2011 Comprehensive Information on Complex Crises

Steven A. Zyck Economic Development Subject-Matter Expert steve.zyck@cimicweb.org

This document provides an introduction to Islamic finance and charts the development of Shariah-compliant financial instruments within Afghanistan. Additional information is available at www.cimicweb.org. Hyperlinks to source material are highlighted in blue and underlined in the text.

n recent years, Afghanistan has increasingly been home to a model of banking and lending, more commonly referred to as Islamic finance, which forbids the charging of interest and which requires the sharing of risks and rewards between financiers and borrowers. In Afghanistan, the populations discomfort with commercial finance, which is commonly perceived as being un-Islamic, and concerns regarding corruption have particularly incentivised Islamic finance. While the so-called Kabul Bank crisis which began in September 2010, adversely affected the countrys finance and banking sector, experts cited in the Financial Times anticipated that an increasing number of Afghans would see Islamic finance as a more reliable and stable alternative to private banks. This report addresses Islamic financial products (securities) and mechanisms and their growth in Afghanistan. It is first, however, important to explain what exactly Islamic finance is and how it differs from non-Islamic (conventional) finance.

Understanding Islamic Finance

iscussions of Islamic finance, which is rooted in the 1,400-year-old Fiqh al-Muamalat al Maliah (Islamic code for financial transactions), have commonly confronted misperceptions, according to Islamic finance experts M. Kabir Hassan and Mervyn Lewis. At its most basic, Islamic finance forbids investment in businesses contrary to Sharia law. Sharia, which is primarily based upon the Koran and the teachings of the Prophet Mohammad, forbids Muslims from investing in or profiting from tobacco, alcohol, gambling, pornography, prostitution and weaponry. Islamic finance is also guided by Sharias banning of usury, which is the charging interest or high fees for the use of money. More broadly, Islamic principles suggest that money should not be self-generating (i.e., that it has no time-value and should not grow without work and/or risk-taking). Globally, the level of assets invested in Islamic financial products has increased rapidly. For instance, a recent study indicates that the amount invested in Islamic finance grew by 37% in 2007. The total amount of assets invested in Islamic securities as of the end of 2010 exceeds USD 1 trillion globally, according to figures from financial services company Ernst & Young cited by the Islamic Financial Industry News Centre.

MONTHLY REPORT ON ECONOMIC DEVELOPMENT IN AFGHANISTAN

Monthly Report: Islamic Finance in Afghanistan

While Islam forbids interest-bearing loans, this restriction does not mean that the finance industry is forced to operate with limited profits. Rather, Islamic law forbids financial products which are based on debt rather than on real assets and actual economic activity. In other words, an investor should not profit without producing something or accepting a degree of risk (as in an investment). As such, an Islamic loan may be provided insofar that it is not seen as creating debt for the recipient (or an expectation of interest on the part of the loan provider), according to the Islamic Finance Council of the United Kingdom. The loan-provider, under Islam, is understood more appropriately as an investor or financier who gives funds, for instance, to an entrepreneur and who will benefit to the extent that the entrepreneur is successful. Therefore, the financier will profit if the recipient profits and will lose money if the recipients enterprise is unsuccessful. Hence, loans may only be taken to finance profitable undertakings, and, as stated in an article from the INSEAD business school, Islamic finance would disallow the provision of loans to purchase luxury items for the wealthy as occurred in the case of the recent Kabul Bank crisis or basic needs for the poor (which, under Islam, should be addressed through charity (or zakat) rather than loans). Figure 1. Islamic Versus Conventional Banking: Key Elements
Conventional Banks Source of Funds Depositors transfer money into a bank and are assured a pre-determined rate of return from the bank. Islamic Banks Depositors transfer money into a bank without receiving any guaranteed rate of return; the account holder will receive a return (or loss) proportionate to the overall financial performance of the bank. While varied, the bank does not provide loans but rather invests the money with individuals seeking capital; the bank shares the risk and reward with the borrower and may not be fully repaid if the borrowers investment or business is not successful.

Use of Funds

Borrowers pay back the principal and a predetermined level of interest to the bank (or jeopardise their collateral) regardless of the profit or loss achieved on their investment or business.

Source: Adapted from M. Hasan & J. Dridi, The Effects of the Global Crisis on Islamic and Conventional Banks, 2010, p. 8.

Islamic medium-term notes (bonds), known as sukuk, have also grown in popularity in recent years as a means of financing public (as well as corporate) expenditure. In such cases, purchasing a government bond is not seen as buying debt, as in conventional finance, but as purchasing a share of the government as if it were a publically-traded company, explains Ahs Consulting. Beyond this alternative conceptualisation, the difference between sukuk and government bonds is minimal. What these examples suggest is the significant and often under-appreciated similarity between Islamic and conventional finance despite their different terminology and framing of transactions, according to Mahmoud Amin El-Gamals Basic Guide to Islamic Banking and Finance. Yet Islamic finance is also distinctive from conventional finance and is, in some respects, particularly suited for developing countries. The poor are unable (or not advised) to use Islamic finance for purposes not intended to generate income (e.g., consumption), and investors (or loan providers) are required to carefully consider the soundness of their investments and to support recipients in turning a profit. Financiers and recipients, in essence, become partners, with loan-providers often offering advice and assistance to loan-recipients.
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Monthly Report: Islamic Finance in Afghanistan

Despite these theoretical benefits, implementation may not always reflect the principles of Islamic finance, and Islamic financial instruments often exist alongside commercial and customary forms of finance, reports the Microenterprise Learning, Information and Knowledge Sharing portal (MicroLINKS). Box 1. The Performance of Islamic Banks in the Global Economic Crisis
Recent research by the International Monetary Fund (IMF) suggests that Islamic banks fared better than conventional banks during the global economic crisis which began in 2008. Islamic banks aversion to securities which are not based on real economic activity shielded them from the sorts of debt-based investments and instruments which led to the initial phase of the economic crisis in many Western countries. Islamic banks, hence, have also been increasingly trusted by depositors, and their asset levels have continued climbing throughout the economic crisis. In many respects, Islamic banks out-performed their conventional peers. Yet, once the banking crisis began to affect the broader economy slowing consumption, construction and production on a global level Islamic banks were more vulnerable than conventional banks as a result of their investments in a narrow range of sectors (e.g., energy and construction) and their relatively permissive approaches to risk management. By 2009, however, conventional banks profitability was down only 15% relative to 2007; for Islamic banks, which were then facing the full effect of the crisis for the first time, profitability was down nearly 50%. The IMF ultimately does not take any position on the relative appropriateness of either Islamic or conventional banking but does highlight the relative benefits of each and the importance of reforms which can mitigate their respective risks.
Source: M. Hasan & J. Dridi, The Effects of the Global Crisis on Islamic & Conventional Banks, 2010.

Islamic Banking & Finance in Afghanistan

slamic finance in Afghanistan predates the current international intervention but has seen growth since the post-2001 formalisation of financial institutions, based on reports from the MicroCapital Monitor. In 2006, the Foundation for International Community Assistance (FINCA), a micro-credit provider, became the first micro-finance institution (MFI) to provide non-interest bearing Murabaha Islamic loans. These loans require that sellers or loan providers declare the fee (not interest) which they will expect in return for the loan, a process which is known as cost-plus financing. Shortly after introducing Murabaha loans, FINCA made all of its products Sharia-compliant and only permitted lending to businesses rather than individuals. Numerous non-governmental organisations (NGOs), including Islamic Relief, and MFIs soon followed FINCAs lead after witnessing that a strong market existed for Islamic financial products. Indeed, Shariacompliant loans are greatly preferred by Afghans according to a recent report from the Center for International Private Enterprise (CIPE); CIPEs survey of 738 business owners found that 26% indicated they had not taken out loans given their perception that borrowing is prohibited in Islam. Larger banks soon expanded into the field of Islamic finance in Afghanistan, with Bloomberg noting in early 2011 that seven of the countrys 17 financial institutions offer some form of Islamic banking. Furthermore, as a Business Week article recently reported, the Afghan government is authorising the countrys first Shariabased banks. These three institutions Afghan United Bank, Ghazanfar Bank and Maiwand Bank are
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Monthly Report: Islamic Finance in Afghanistan

indicative of a broader move towards Islamic financial mechanisms. This move is motivated in part by the perception that Islamic banking may draw additional deposits from individuals who perceive commercial banking as un-Islamic while also earning a significant profit. Ghazanfar Bank indicated in 2009 that profits from some of its Islamic products which it had begun offering before Afghan government certification were expected to rise by 36.7% within one year. This bank further predicted that the amount of money deposited in Sharia-compliant accounts, given their popularity among Afghans, would increase by 35.0% between 2009 and 2010. Box 2. Selected Islamic Finance Products Offered by Ghazanfar Bank
Mudarabah Savings Account: This account comprises an investment by the depositor, which the bank is then free to use in any way which is compliant with Sharia law for a pre-determined period of time. When the account matures at the end of the agreed time period the depositor receives a share of the profits in the bank or, if the banks investments lost money, a share of the loss (meaning they would receive less than they deposited). Hire Purchase-i (Auto Aitab): This product is essentially a car loan, though the primary difference is that, while a lending fee is charged, interest rates do not increase, and inflation is not a factor. As in many Islamic financial instruments, a set fee rather than time-based interest is applied. Murabahah Working Capital Financing-i (MWCF-i): This short-term financing mechanism is viewed as an investment by the bank into the recipients enterprise. A repayment schedule is made, and a share of the investment-related profits is turned over to the bank in lieu of interest.
Source: Ghazanfar Bank website, December 2010

Afghanistans Central Bank, which is more commonly referred to as Da Afghanistan Bank (DAB), includes Islamic banking as a key component of its strategy for 2009 to 2014. In a recent interview, one DAB official suggested to Bloomberg that the Afghan government plans to sell Islamic bonds (sukuk) once Islamic finance has been more firmly established throughout the country. As DABs strategy notes, Islamic finance, by being more palatable to segments of the population who view most commercial finance as un-Islamic, may draw larger sums of money into the formal banking system. The chief executive of Bank-e Millie Afghan said in an interview with Bloomberg in late 2010 that the expansion of Islamic banking could attract as much as USD 3 billion into the formal financial system within four years. At present, large segments of Afghans assets are not kept in banks but instead remain stored in homes or deposited with a range of money traders known as hawala dealers, which have been the subject of increased scrutiny for their alleged role in handling the proceeds of corruption and narcotics trafficking in Afghanistan. In an attempt to undermine such practices, DAB is considering a regulatory system which includes two tracks: one for conventional banking and another for Sharia-compliant institutions and transactions. Doing so, DAB notes, will require a comprehensive and multi-tiered Sharia compliance mechanism to lend customers and investor confidence in the Islamic Banking Industry, something which will be particularly important given the potential for banks to offer seemingly Islamic investments without accepting the associated risk (e.g., by pressuring borrowers to repay all borrowed money even if their business failed). Such a regulatory system is particularly critical in the aftermath of the banking controversy surrounding Kabul Bank in September of last year. Kabul Bank, which reportedly lost several hundred million dollars last year, was founded upon what it described as Islamic products and services, including Bakht and Qismat.
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Monthly Report: Islamic Finance in Afghanistan

Bakht, which translates into fortune, comprised a lottery into which depositors in the bank were automatically entered if they met certain criteria (e.g., a particular level of savings). Drawings were regularly held, and prizes such as jewellery, cars, cash and houses were distributed to winners. Yet by avoiding the term lottery, Islams ban on gambling was circumvented. The same held true for Kabul Banks use of Qismat, another prize-drawing that capitalised upon the notion of sharing or dividing wealth between account holders. While framed as forms of Islamic finance, Bakht and Qismat were viewed as quasi-Islamic attempts to circumvent Islams prohibition on gambling. It remains unclear to what extent such banking products and the larger crisis at Kabul Bank have affected the Afghan populations attitude towards Islamic finance.

Conclusion

egardless of the challenges for Islamic finance, it is widely preferred by Afghans, according to the aforementioned CIPE surveys, and is considered likely to expand widely within Afghanistan in future years. With only 3% to 10% of Afghans currently holding accounts in the countrys commercial banking sector, Islamic finance may draw personal savings away from hawala dealers and out from under mattresses and personal safes across the country and provide a much-needed injection of capital into banks and businesses. As the head of financial services as DAB recently stated, Islamic banks will not only earn the confidence of ordinary Afghans but will also allow banks to more freely provide loans to aspiring entrepreneurs and develop the countrys economy.

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