An Introduction to Islamic Finance: Theory and Practice, Second Edition

An Introduction to Islamic Finance
  • Book Title:
 An Introduction To Islamic Finance
  • Book Author:
Abbas MirakhorZamir Iqbal
  • Total Pages
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Adherence to the Essence and Spirit of Shari’ah

 The Shari’ah is not just a set of laws; such laws have well-meaning objectives, commonly referred to as the objectives of the Shari’ah (maqasid-al-Shari’ah). These are designed to implement the essence or the ideology of Islam, which primarily revolves around promoting unity, social justice, social welfare, the preservation of property rights, and economic development.

 Therefore, any attempt to develop a product or process that runs counter to these core objectives will not be acceptable. However, by keeping these objectives in sight, financial engineering will lead to an increase in overall social welfare.

The objectives of the Shari’ah provide the first line of defense against the introduction of any innovation that is deemed to have the potential for being counterproductive under any market conditions. For example, financial engineering cannot result in any product that leaves either lender or borrower open to exploitation by the other under some market conditions. Before approval can be given for any innovation, there would have to be an impact assessment at the macro level. Although this would not be an easy task as it involves subjective and qualitative judgment, the consistent application of the core principles would serve that purpose.

Freedom of Contract An understanding of the laws governing contracts in Islam is critical. Individuals have wide freedom of contract and the contracting parties are free to engage in any transactions not prohibited by the Shari’ah. In other words, any transaction is permissible so long as it does not contain any of the prohibited elements of riba, gharar, qimar and ikrah.

Historically, Shari’ah scholars would not dictate how a contract should be formulated, but it was a common practice by economic agents to bring a contract to the Shari’ah scholar who could only declare its legitimacy or non- compliance by testing for the prohibited elements. If the Shari’ah scholar did not find any of the prohibited elements, the contract was given the blessing of compliance.

This practice implies that rather than imposing restrictions on the contracts, Shari’ah gives freedom of contract to the parties so that they can develop new tools and mechanisms of financing and lending, and the role of the Shari’ah scholar is limited to ensuring that the contract is valid.

Financial instruments and services should be viewed as sets of contracts, which identify the rights and obligations of each party. The Shari’ah scholar can examine the contract to verify that these rights and obligations are preserved according to the notions of contracts and property rights in Islam.

This simple principle has significant implications. It means that the basic contracts can be used to build more complex building blocks, opening up the possibility of spanning products to meet customized risk/return profiles. This contradicts the common impression that Shari’ah rules hinder creativity and the expansion of financial products and services. Islam encourages entrepreneurship, which signifies risk taking, innovation and creativity that will encourage financial products, processes and services which promote risk sharing and equity participation.

Availability of Basic Building Blocks Almost all of the complex financial instruments in today’s conventional financial markets can be broken down to a set of basic instruments. For example, a floating-rate bond with a cap and floor on its coupon is nothing but a plain-vanilla floating bond with a call and a put option. Even call and put options can be replicated using cash and fixed-income instruments. No effort to introduce financial engineering into the Islamic financial system can take place without an understanding of the basic building blocks of that system and the principles that can be applied to build more-sophisticated instruments.

Customizing Risk/Return Profile It is also critical to develop an understanding of the spectrum of the risk/return profiles of different financial instruments. Often the Islamic financial system is equated with an all equity-based sys- tem, which ignores the fact that the system also has several other types of contracts which are not based on profit/loss-sharing. Like sales, trade financing and leasing contracts constitute a large portion of the system, but these are not based on equity and have a risk/return profile that is very similar to a conventional fixed-income security—a vital part of the more exotic financial instruments.

While the instruments based on murabahah, salam, or ijarah contracts may resemble an interest-bearing, fixed-income instrument, these are allowed and recognized by the Shari’ah and carry different risk/return characteristics. As discussed earlier, the introduction of securitized assets will exploit these instruments to design and customize risk/return profiles that are critical for the efficient construction and man- agement of portfolios.

Promotion of Risk Sharing and Reduction of Leverage The prohibition of interest in Islam curtails the creation of leverage through debt. Instead, the system promotes a balanced sharing of risks and rewards through equity- and partnership-based financial contracts. Following these principles, the financial engineer will focus on developing products which promote risk sharing through making full use of equity (musharakah) and partnership (muda- rabah) contracts. Not having access to debt, the financial engineer will find it difficult, if not impossible, to create leverage.

Materiality and Linkages The founding principle of Islamic economics is to promote the real sector—that is, goods and services—and to link the financial sector to it as closely as possible. Shari’ah, therefore, insists on the integra- tion of the two sectors to achieve balanced and sustained economic growth. If they are not coupled well, transaction costs increase and efficiency suffers. Financial engineering in Islam will focus on innovations which promote real- sector activities and offer innovative ways to finance these activities.

By using risk-sharing contracts, the financial engineer will rely on asset-linked securi- ties through the securitization of real-sector assets. Shari’ah rules concerning ownership also ensure that there is clarity in asset ownership by the investor and thus the issue of “remoteness” of assets and ownership witnessed in the conventional system will be minimized.

Transparency and Simplicity Financial engineering in the Islamic financial system seeks to eliminate gharar through advocating the reduction of asymmetrical information between the parties. Products would be designed to avoid having excessive uncertainty regarding the future payoffs and risks for either party. Where there are unknowns, these would be fully disclosed at the time of the contract. A judicious application of this principle will make the products transparent and will reduce their complexity.

Different Approaches to Financial Engineering

The principle of financial engineering to introduce advanced financial instruments can be applied in the following ways:

Reverse Engineering or “Wrapping” The first approach entails taking an existing instrument in the conventional system and evaluating each of its components to find the closest substitute from the basic set of Shari’ah-approved instruments. This means breaking down the instrument and then rebuilding it, using equivalent instruments from the set of Shari’ah-approved instru- ments. This approach is very similar to a common practice where conven- tional instruments are disguised under Shari’ah-friendly names such that Shari’ah “wrapping” takes place around the conventional instruments to produce an Islamic instrument.

The major advantage of this approach is the instant recognition and understanding it gets from the practitioners of conventional finance; this paves the way for efficiency and the integration of Islamic financial markets into the conventional system.

This approach may be used for determining the legitimacy of a product when it is introduced into a conventional market. This will make it easy for the regulatory authorities of the host country to understand the instrument, which will facilitate its speedy approval.

Extreme care is required in this approach in order to avoid any misidentification of close substitutes. Any misidentification or use of a wrong substitute can not only break the trust of investors, but will also create a reputation risk for the industry. All efforts should be made to avoid any contamination from instruments that are close substitutes but not fully Shari’ah– compatible. Contamination may occur when an Islamic instrument or con- tract is used where its intended usage is either doubtful or questionable, or some important features or conditions of the contract are compromised. This danger of contamination will increase as the level of complexity of the instrument increases.

Innovative Engineering A second approach to financial engineering, prefer- able in principle to “reverse engineering,” is to design instruments de novo from an established menu of Islamic instruments. The result will be a new array of instruments, each with a unique risk/return profile, that can be bought and sold in specialized markets compatible with Shari’ah principles.

Since this approach requires a deep understanding of the Islamic economic and financial system as well as the risk/return characteristics of each basic building block, it is a long-term solution and requires extensive research and commitment. Although this approach is better aligned with the essence of the Shari’ah, pioneering new frontiers in a different paradigm always poses new challenges and takes time. Some of the prerequisites of or for an Islamic financial system, such as efficient markets, information symme- try and Shari’ah-compatible property rights and regulatory and supervisory laws, are absent from most of the developing Islamic countries.

Although this second route is, in principle, the better approach, operational difficulties associated with it impose constraints and force compromises. It is conceivable that given the pressing need for innovation, the first approach will dominate in the short term, and that some combination of the two approaches will be adopted in the medium term.

However, the full potential of the system will only be achieved if serious efforts are made to introduce new instruments that provide unique risk/return characteristics that are equally desirable for Islamic and non-Islamic financial markets.

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