Title

Islamic Financial Structures as Alternatives to International Loan Agreements: Challenges for American Financial Institutions

Abstract

In the past few decades, the Muslim countries have witnessed considerable economic growth. The markets of these countries spanning from North Africa to South East Asia, are expanding at a fast pace, and gradually are turning into important international economic centers. The expansion and sophistication of the Islamic markets, as well as increasing demand for Islamic financial products by borrowers, have spurred a movement toward Islamization of different aspects of economic activities in these markets. This movement has resulted in the creation of an Islamic financial market alongside the conventional financial markets. The data on the size of the Islamic financial market on the global level indicate that 265 Islamic financial institutions with a collective capitalization in excess of $13 billion have been formed, with assets amounting to over $262 billion, investments over $400 billion, and deposits in excess of $202 billion. American banks and other financial institutions have become interested in this growing non-conventional market for financial products, and are providing financial facilities to foreign business entities operating under Islamic principles. Their path to this market, however, is not smooth, and they need to innovate and adjust to the requirements of Islamic finance along the way.

This paper aims at introducing the main features of the Islamic finance as applicable to an international loan agreement, and at addressing the special challenges that an American financial institution will face in doing business under Islamic principles in the Middle East, North Africa and other Muslim regions of the world. In Part I, the principles of Shari’a (Islamic Law) applicable to financing transactions will be explained. Two principles of Shari’a have important structural implications for a loan agreement. One is the prohibition of interest (riba), and the other is the prohibition of risk/uncertainty (gharar). Part II deals with the available contracts that can be used to structure an international loan agreement in accordance with Shari’a. These contracts include Islamic partnerships (musharaka and mudharaba), leases (ijara), cost-plus sales (murabaha), and commissioned manufacturings (istisna’). In Part III, the challenges arising from using the Islamic contractual structures for financing purposes, and the problems that an American bank encounters in this area will be analyzed. Especially, in this section, the possible legal inconsistencies between Islamic financing mechanisms and the Western approaches, and the possibility of arbitraging the two systems to one’s advantage in an integrated system will be addressed. It must be noted, although the principles and some of the analyses explained below are also applicable to the growing Islamic financial markets in the U.S., this paper primarily focuses on the challenges that the American financial institutions face in cross-border Islamic financial transactions.

Disciplines

Banking and Finance Law

Date of this Version

September 2004