I’ve started writing about Islamic finance as of a few months ago. It’s a fascinating, bizarre market, fusing as it does the world of ancient religious law with the world of international finance. And it’s an increasingly important market, because the Middle East is suddenly where all the capital is, so companies, banks, funds and even governments are scrambling for their Koran to work out how to attract this capital.

Particularly interesting to me is the world of Islamic debt. The market for Islamic bonds, or sukuks, has grown from almost nothing in 2000, to $60 billion last year, and is forecast to pass the $100 billion mark in the next few years. The UK is expected to issue its first sovereign sukuk later this year.

Each deal that gets arranged has to get a fatwa approving it from an Islamic scholar. In practice, bankers say that there are only 10 or so Islamic scholars who are well-known and credible enough for their ruling to have weight. So you have this handful of elderly scholars in Dubai, Bahrain and Riyadh giving their scholarly okay to tens of billions of dollars worth of deals.

Their rulings are very important because the whole idea of Islamic debt is a bit shaky. Islam forbids usury, or the earning of interest on loans. Investors have to be equal partners in economic projects, sharing in profits and losses, with aligned incentives. Otherwise lenders might have an incentive to profit from a borrower’s misery, like UK banks profit from credit card borrowers’ misery.

So the structure that has been invented in the last few years backs the sukuk with assets, which the investor ‘buys’ from the borrower, and then the borrower ‘buys’ them back at face value when the bond matures. It’s a bit of a fiddle, in effect. Now, however, just as the sukuk market is getting really big, one of the leading scholars who cover the market has ruled that 85% of sukuk are haraam, or non-compliant with Shariah.

Sheikh Muhammad Taqi Usmani, chairman of the (deep breath) Accounting and Auditing Organization for Islamic Financial Institutions, or AAOIFI, has issued a solemn ruling that assets backing sukuk must be genuinely sold to the investors.

And moreover, the Shariah supervisory boards for sukuks, on which scholars like himself typically sit, must pull their finger out. The AAOIFI ruled: “Shariah supervisory boards must not consider their responsibility to be over when they issue a fatwa on the structure of a sukuk. Rather, they must review all contracts and documentation related to the actual transaction, and then oversee the ways that these are implemented in order to be certain that the operation complies at every stage with Shariah guidelines”.

Obviously rattled by the global debt crisis, the AAOIFI also adds: “the Shariah committee advises Islamic financial institutions to decrease their exposure to debt-related operations and to increase their operations based on the partnerships and the sharing of risk and reward and thereby achieve the higher purposes of the Shariah. And all praise is due to Allah, Lord of All the Worlds!”

If only Ben Bernanke’s pronouncements could be more like that.

Anyway, what does this mean? Will the Islamic debt market disappear overnight? No, it just means deals will be a bit more expensive, but they will keep on coming. Scholars like Usmani support the booming market, I would suggest, because they see it as a way of spreading the influence both of ethical business practices, and of Shariah law. It’s a form of soft power for the Islamic world.

On the other hand, what interests me about this market, and these sorts of religious debates, is that it reminds me of the move in the Christian world from the Medieval to the Renaissance world-view.

A key part of that shift was the Commercial Revolution of the thirteenth and fourteenth centuries, when religious scholars, particularly the Dominicans, managed to find a space within the Church’s anti-usury laws for some forms of lending and financial activity. They created the space for a huge boom in commercial lending, and also helped usher in a more pragmatic and flexible attitude to religious law. Islamic finance’s mullahs today, it seems to me, are the equivalent of the Dominican friars of the Middle Ages.

Eventually, hundreds of years later, the financial sector in the West is completely liberated from the control of religious bodies like the AAOIFI. We have our toothless FSA, we have our woolly friends in the corporate social responsibility departments of corporations, and we have the rating agencies, the guardians of financial transparency, who helped cause the present financial crisis by giving indulgent ratings to the very banks who paid them. (Hmmm, selling indulgences, that sounds familiar…)

But can the Islamic model really work better? Can 10 elderly scholars really be expected to keep an eye on every deal in a $100 billion market? And how are they recompensed for their services? Do the banks who get them to provide fatwas provide them with salaries, gifts, perks, new libraries for their mosques?

I wonder if religious ethics and finance can ever be balanced, or whether the corrosion of capital will always triumph.

Jules Evans, a columnist of Eurasian Home website, London

April 16, 2008