Financial Innovation and Engineering in Islamic Finance pdf

FINANCIAL INNOVATION AND ENGINEERING IN ISLAMIC FINANCE – Book Sample

Introduction

1.1 Background

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).

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(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.