What is and is not Islamically correct?

On the surface, Dr Mahmoud El Gamal would seem an ideal candidate for an Islamic bank account. He is a committed Muslim; he is head of the Islamic finance department at Rice University in the United States; and he's such a renowned expert in the field of Islamic finance that the US Treasury recently hired him as its adviser on the subject.

However, El Gamal has turned his back on Islamic retail banking products. Why? Because rather than being legitimate, sharia-compliant offerings, he sees the majority as simply conventional banking products with an Islamic gloss.

'I am not a customer!' El Gamal told delegates at the recent International Islamic Finance Forum in Istanbul. He, and others, argue that many of today's Islamic finance products have lost sight of the two main principals of Islamic finance.

First, that it should prevent people becoming trapped in a cycle of debt - if people can only raise finance against their assets, they cannot owe more than they are worth. Second, that rates of return are linked to the market yield on an underlying asset, such as the rental on a property, to prevent financiers charging excessive premiums.

In practice, this means no interest, or riba, and that finance should be backed by an underlying asset. Good as gold. Some of El Gamal's fiercest criticism is reserved for a product called tawarooq. Tawarooq is not backed by assets.

Tawarooq problems

It is structured around a commodity, such as copper or gold, to make it appear asset-backed. But El Gamal argues that, in reality, it is an unsecured loan, in that it is not backed by an asset such as a house or a car owned by the person raising the finance.

He says it could be described as 'a trick for riba.' Not everyone in the industry agrees. Leading sharia scholar Sheikh Nizam Yaquby argues in favor of using tawarooq in certain circumstances, stressing that ancient scholars, such as Ibn Tamiyya, had ruled that it is not prohibited.

'Ibn Tamiyya did not prohibit tawarooq in his books,' insists Sheikh Yaquby. He pointed to the case of the recent award of a second mobile telecommunications license in Saudi Arabia. A consortium led by UAE operator Etisalat won the second license in July 2004, and immediately had a funding requirement of more than $1 billion.

However, the strict nature of the license award meant Etisalat could not structure a conventional Islamic financing. Tawarooq provided a solution.

'If Etisalat did not come up with the financing, the number-two bidder - a South African company - would have been awarded the license. Islamic financial institutions wanted to take part in this. The only way Islamic banks could finance this was through tawarooq. Even scholars who would not [normally] accept tawarooq accepted it. So tawarooq was okay for Etisalat.'

Sheikh Nizam insists that tawarooq has a positive role to play in other areas. He said it can be particularly useful for financing personal medical expenditure. If a Muslim needs $20,000 to finance surgery, he cannot use the surgery as an asset, unlike in the case of buying something tangible like a car.

'If we do not allow it, you let the person take a riba loan.' What does mainstream Islamic finance think of tawarooq? Sharia scholars have deliberated on the issue, and issue fatwas, or rulings, on the subject. Essentially, they say that tawarooq is acceptable, but only in exceptional circumstances where asset-backed alternatives are not available.

Mainstream

Critics like El Gamal are unimpressed, citing the growing use of tawarooq, particularly in the Gulf states. He said that while sharia scholars have ruled that tawarooq is acceptable in only certain circumstances, in reality it is entering the mainstream.

'While fatwas will say it will be used only as a last resort, in reality its low transaction costs mean it will become a normal mode of operation,' says El Gamal. 'If you can get unsecured finance easily, putting that clause in the fatwa is meaningless.'

Transaction costs are central here. The complex, asset-backed structuring of Islamic finance means it will inevitably be more expensive than a conventional loan - there are simply more links in the chain in Islamic finance. However, critics claim that in a bid to stay competitive with conventional retail and investment banking rivals, some Islamic institutions are effectively cutting corners.

The Turkish Islamic finance market is a powerful example of this. The country's Islamic finance institutions are almost as efficient as its conventional banks, despite additional transaction costs. 'The tricks are almost as efficient as conventional finance,' says El Gamal. 'Is it Islamic finance, or Islamicized conventional finance?'