FINANCIAL INNOVATION AND ENGINEERING IN ISLAMIC FINANCE – Book Sample
Since the global ﬁnancial crisis of 2008, interest in the Islamic banking and ﬁnancial system has sharply increased. After the near collapse of the world ﬁnancial system and the bankruptcies and government bailouts of several long established ﬁnancial institutions (see e.g. Plosser 2009; Poole 2011; Duska 2009; Jameson 2009), attention has shifted to the newly emerged Islamic banking system. The focus of examination is whether Islamic banks have been impacted by the ﬁnancial crisis in a similar manner to the conventional banking system.
The question always asked was how Islamic banking and its ﬁnancial products were and are different from its conventional counterpart. Also, what underpins the ﬁnancial innovation and engineering processes to make this banking system immune, to some extent, from the recent ﬁnancial crisis?
Comparisons between Islamic and conventional banking have also surfaced in other arenas. In Anti-Capitalist protests around the world, there was considerable anger towards the conventional ﬁnancial institutions.
These events were thought provoking and raised many questions about Islamic ﬁnance and banking that need to be seriously considered. Does the Islamic ﬁnancial system really hold a solution, or at least a partial solution, to our ﬁnancial problems for people who have lost faith in capitalism and the current practices of the ﬁnancial system and its institutions?
What shielded the Islamic ﬁnancial and banking system from the ﬁnancial storm that destroyed signiﬁcant parts of our conventional ﬁnancial and banking system? How did the Islamic ﬁnancial system develop its principles and foundations in relation to ﬁnancial innovation and engineering, where did Islamic ﬁnance come from and what are the characteristics that this system represents?
We aim in this book to answer the above questions as possible and shed the light in a robust academic manner on the system of ﬁnancial innovation and engineering in Islamic ﬁnance and banking. Recent academic research (Plosser 2009; Poole 2011; Duska 2009; Jameson 2009) has suggested different reasons for the failure of the ﬁnancial and banking systems that triggered the ﬁnancial crisis in 2008.
Kling (2010) summarises that the main focus was on two competing narratives: moral failure and cognitive failure. The capital regulations played a fundamental role in fostering the behaviour that created the ﬁnancial crisis. Occurring in parallel to this under-regulation were subprime mortgages, underwriting criteria, the sophisticated ﬁnancial innovation and engineering, principles of ﬁnancial product development and debt securitisation.
These dual processes combined to trigger the 2008 ﬁnancial crisis, which is still affecting the economy and society as a whole (Plosser 2009; Poole 2011; Duska 2009; Jameson 2009). Yet the role of banks and their practices in causing the current ﬁnancial crisis is underplayed and under analysed. This lack of scrutiny has occurred in spite of a colossal sum of taxpayers’ money being injected to save banks, which themselves have played crucial part in the current ﬁnancial crisis.
By examining the banking practices that were the root cause of the recent ﬁnancial crisis as outlined in the literature, they all lead to two intertwined, overriding concerns, namely cultural and behavioural failures. These failures impacted the processes of initiating new ﬁnancial innovation, ﬁnancial engineering, the new ﬁnancial product development (NPD) and the way these products were introduced and sold in the market by circumventing legal rules and regulations.
New, light touch regulatory changes, according to Turner (2012), were introduced by ﬁnancial regulators into banks in order to address this issue. As an example, the UK government has introduced the separation of commercial and investment banking functions, which will come into effect around 2019. However, this does not represent any real reform of the ﬁnancial system and banking system, because it does not fully address the working culture underpinning banking practices.
This research, therefore, adopts the view that the cultural and behavioral failures are the overriding concerns, as the basis for exploring and explaining these issues in the context of the Islamic ﬁnance and banking.
The behavioral approach and culture of the ﬁnancial innovation and engineering processes are crucial elements to be assessed in order to explore what constitutes a religiously guided process towards ﬁnancial innovation and engineering.
1.2 Importance of Financial Innovation: Realising the Potential
Growth of the Islamic ﬁnance is in progress with key players pioneering new ways for consumers to generate a proﬁt from their wealth in a Shariah compliant way. However, the challenge does not end here. Whilst product innovation needs to keep pushing the boundaries, consumer education and awareness must also be increased
to drive product take-up for an increased market share. The industry’s success so far proves that this is not mission impossible (Iqbal 1999).
Rapid surge of ﬁnancial innovations in international ﬁnancial markets was witnessed in the 1980s. Financial innovations transformed the traditional ﬁnancial and banking markets into highly sophisticated markets featuring high degrees of liquidity and a wide-array of instruments to share and transfer various sources of risk. Such ﬁnancial instruments are believed to be contributable factor to the recent global ﬁnancial crisis (Philippe and Da Silva 1995: 5).
The bank for International Settlement (BIS 1986) identiﬁes three types of ﬁnancial innovation activities with the most signiﬁcant impact on the markets innovations to enhance liquidity, to transfer risk (price and credit), and to generate revenues (from credit and equity).
Financial engineering can be viewed as a process of building complex instruments utilizing basic building blocks or unbundling and repackaging different components of existing ﬁnancial instruments, e.g. return, price risk, credit risk etc. Most of ﬁnancial innovations today are ﬁnancial ideas that are engineered to incorporate highly liquid instruments and derivatives that are nothing but a structure based on simple and basic set of instruments (Iqbal 1999).
A close scrutiny of instruments underlying Islamic ﬁnancial system reveals that such instruments have similar characteristics of many of today’s basic building blocks. It is a matter of designing more complex instruments without violating any of the boundaries deﬁned by Shariah rules (Iqbal 1999). Therefore, based on the above discussion and for the purpose of deﬁning key terms used in this book, this book adopts the following meaning when referring to, ﬁnancial innovation, ﬁnancial engineering and new product development (NPD):
(a) Financial innovation is the generation of new idea for a ﬁnancial product with the objective of securing market competitiveness, addressing risk, generating revenue or enhancing liquidity.
(b) Financial engineering, on the other hand, is the process of employing basic ﬁnancial tools to build what may appear as a complex structure in order to provide a suitable design for the new ﬁnancial innovation.
(c) New product development process (NPD) is the overall process that sets the steps for taking a new ﬁnancial innovation from the concept or initiation phase, through the ﬁnancial engineering and design phase, by following the different phases and governance controls. This would lead to a complete ﬁnancial product that complies with all applicable Shariah rules, in order to be intro-duced in the market. This involves taking into account all operational, market, system and distribution channels and sales requirements. The requirement of a ﬁnancial engineering would determine whether the NDP requires such phase or not, if it is designed on a simple single ﬁnancial instrument.
The above technical meaning and deﬁnition of the three identiﬁed terms that this work revolves around, would be the approach used herein and throughout this book when referring to any of them. The Shariah principles, rules and ethics that should be observed are incorporated into the processes of those technical terms in this book.
1.3 What Makes a Bank Islamic
The basis for Islamic ﬁnance lies in the principles of the Shariah, or Islamic Law, which is taken from the Qur’an and from the example of Prophet Muhammad (peace be upon him). The Islamic form of ﬁnance is as old as the religion of Islam itself (Visser 2009: 34).
Central to Islamic ﬁnance is that money itself has no intrinsic value. As a matter of faith, a Muslim cannot lend money to, or receive money from someone and expect to beneﬁt from this alone. This is why interest (known as riba) is not allowed and is considered effortless proﬁt (Ahmed 1976; Siddiqi 1981). Therefore, the exclusion of interest from its activities is the founding principle of an Islamic bank.
Instead, according to Islam, money must be used in a productive way and wealth can only be generated through legitimate trade and investment. It is also essential that all parties share the business risk involved in the activity. As a result, the parties concerned are each entitled to a share in the proﬁts that are generated (Iqbal 1999).
Islamic banking therefore uses various principles recognised as Shariah compliant such as Ijara (leasing), Musharaka (partnership) and Mudaraba (proﬁt sharing agreement), full explanation of all common principles is provided in Chap. 2, Sect. 2.4. Islamic banks use these, and other, Islamic ﬁnance principles to develop Shariah compliant ﬁnancial products, such as savings accounts, investment, com-mercial and development ﬁnance and home ﬁnance, which allow Muslims to conduct their ﬁnances in an Islamic and ethical way.
1.4 Values Embedded in the Islamic Banking Products
Islamic banking and conventional banking are based on different values and the absence of interest in Islamic banking is one of the key differentiators. However, there are other important differences:
(a) Islamic banking (IB) is asset-backed (Ahmed 1976; Siddiqi 1981); which means that Islamic banking should not conduct business unless it has the funds or assets to back the transaction. As a result, Islamic banking should avoid putting its customers’ assets at risk through the use of sophisticated ﬁnancial instruments (used in the conventional banking system) that involve speculation.
So, for home ﬁnance e.g., Islamic banks use their own funds, or the savings deposits from their customers, to provide ﬁnance (Al Zarqa 2012: 48–51). The customer and the bank buy the property jointly under one of the ﬁnancing structures (this structure is based on a diminishing co-ownership with lease)
used by Islamic banks for that purpose. The monthly payment increases the customer’s share in the property and includes rent on the share that the IB owns. At the end of the ﬁnance term the customer will own the property outright and the IB will transfer the legal title to the customer.
For savers, Islamic banks invests their depositors’ money in low-risk commodities trade in inter-banking deposits placements with counterparty Islamic banks, or conventional banks with an Islamic trade desk, and in the IB’s assets products. The return received from both of these activities is shared and distributed as proﬁts to savings customers. By following this asset-backed system (as there must be an underlying asset for any ﬁnancial transaction), Islamic banking as a whole, is not exposed to the same risks as conventional banks.
(b) The values underpinning Islamic banking stipulate that the source of funding, proﬁts and business investments cannot be in/from businesses that are consid-ered unlawful under Shariah, such as companies that deal in interest, gambling, pornography, speculation, tobacco, arms and other commodities contrary to Islamic values (Visser 2009: 34).
(c) The principles of fairness and transparency play a large role in Shariah com-pliant banking, although it might not be fully implemented in practice. For customers this translates itself in different ways. For example, a customer taking out a home ﬁnance product would only be charged a fee that reﬂects the administrative costs the bank incurs to arrange the ﬁnance. Small print of associated risks, extra terms and conditions that shift risk unfairly to customers and hidden charges that are not clear upfront are practices against Islamic teachings for ﬁnancial transactions (Iqbal 1999).
FINANCIAL INNOVATION AND ENGINEERING IN ISLAMIC FINANCE, FINANCIAL INNOVATION AND ENGINEERING IN ISLAMIC FINANCE, FINANCIAL INNOVATION AND ENGINEERING IN ISLAMIC FINANCE, FINANCIAL INNOVATION AND ENGINEERING IN ISLAMIC FINANCE
(d) The whole premise of Islamic banking is to provide a way for society to conduct its ﬁnances in a way that is ethical and socially responsible. Interest is forbidden in Islam because it is considered effortless return that does not serve the real economy (Al Zarqa 2012: 36). Conventional ﬁnancial instruments, for example short-selling, futures and options contracts and derivatives, are also not permit-ted as they would create risks that do not promote the ﬁnancial well-being of the parties involved, and society as a whole. In addition to, some of those ﬁnancial products lack certain requirements to be acceptable as Shariah compliant ﬁnancial products (Al Zarqa 2012: 36).
However, trade, entrepreneurship and risk and proﬁt sharing activities are encouraged, and these are the ﬁnancial principles that underpin the products and ﬁnancial innovation offered by Islamic banking. These are complemented by ethics and values such as inclusivity, transparency, integrity, respect and fairness. The two are combined to offer a banking system that is built on a different and possibly more ethical footing, than conventional banking.
To read more about the Financial Innovation And Engineering In Islamic Finance book Click the download button below to get it for free