Globalization and Islamic Finance: Convergence, Prospects and Challenges
GLOBALIZATION AND ISLAMIC FINANCE – Book Sample
Policy Recommendations – GLOBALIZATION AND ISLAMIC FINANCE
In the previous section, we highlighted the gaps between the current practices of Islamic ﬁnance and its paradigm version. Policy makers in countries that are serious about developing a ﬁnancial system according to the principles of Islam should appreciate the challenges in developing such a system and the approach to take in overcoming those obstacles. In this section, we list some recommendations.
6.3.1 Development of institutions
There is no doubt that well-developed political, economic, and legal institutions are essential to facilitate ﬁnancial contracting and are a necessary element of a robust ﬁnancial system. Better institutions promoting checks and balances and the quality of governance can affect ﬁnancial markets in several ways. For example, Akitoby and Stratmann (2009) show that better institutions lead to better ﬁscal policy, which reduces a country’s default risk and, ultimately, lowers its cost of borrowing.
The signiﬁcance of institutions increases with market integration and globalization, where economies with established institutions attract investors and capital, as opposed to economies where institutions are weak, ineffective, and inefﬁcient. Starting with the legal system, unless there is clarity with respect to creditors’ and borrowers’ rights, the protection of property rights, and rights on collateral in cases such as default, it will be difﬁcult to build an efﬁcient ﬁnancial system.
The prevailing legal systems are predominantly based on the conventional legal system, which may or may not have provisions for handling speciﬁc treatment of Shari’ah rules. Furthermore, legal systems in place in Islamic countries have enforcement shortcomings, which are a deterrent for any investor. Therefore, the development of supportive legal and tax codes, and of a harmonized regulatory framework based on Islamic law, is critical for the Islamic ﬁnancial services industry.
GLOBALIZATION AND ISLAMIC FINANCE
Development institutions, such as rating agencies, audit agencies, trade associations, and dispute resolution organizations, also play a vital role. The function of rating agencies should not be limited to the rating of creditworthiness, but should also be extended to evaluating and giving an opinion on compliance with and the quality of Shari’ah practices. The scope of institutions such as the International Islamic Rating Agency (IIRA) should be expanded to rate large numbers of counterparties with whom a ﬁnancial institution may engage in a mudarabah-like partnership.
Development of private credit-rating agencies in all Muslim countries to facilitate the task of Islamic ﬁnancial institutions in choosing their counterparties has been proposed.16 Similarly, the scope of an audit should include the effectiveness of controls on new product development to ensure Shari’ah compliance.
Strengthening of the regulatory and governance framework
One may notice the omission of a detailed discussion on the regulation of Islamic ﬁnancial institutions. The reason for this omission is that regula- tion is one area where there have been stark developments in recent years and the progress in this respect is worth appreciating. Credit goes to the collective efforts of setting up the Accounting and Auditing Organization of Islamic Financial Institutions (AAOIFI), followed by the Islamic Finan- cial Services Board (IFSB), with the help of multilaterals such as the IMF and Islamic Development Bank (IDB). In its short life, the IFSB has made a noticeable mark on international ﬁnancial circles in promoting Islamic ﬁnance and developing standards and other regulatory frameworks. If this trend continues, there is optimism about further globalization of Islamic ﬁnance. However, more work needs to be done.
Whereas the current ﬁnancial crisis has highlighted vulnerabilities in ﬁnancial systems, it has also recognized new challenges facing the regulation of cross-border and highly integrated ﬁnancial markets. Prior to the crisis, the emphasis was on market discipline and on promoting standardization and harmonization of rules and practices.
International ﬁnancial interme- diation was subject to the growing set of standards and codes, such as the Basel Core Principles on Banking Supervision, transparency and monetary management guidelines, IOSCO capital markets standards, corporate gov- ernance rules, anti-money laundering (AML), and counter-ﬁnancing of ter- rorism (CFT). The objective was to enhance the efﬁciency of the system by delivering the best services at the lowest cost to the consumer. However, the ﬁnancial crisis has exposed the need to strengthen the stability of the system, which has led to the development of a consensus that there is a need for more regulation.
The current situation offers both opportunities and challenges for the Islamic ﬁnancial industry. In terms of opportunities, the stakeholders of the industry can inﬂuence policy formulation at early stages to ensure that the new regulatory environment is more “Islamic ﬁnance friendly” and addresses some of the key issues in regulating Islamic ﬁnancial insti- tutions. These issues include the treatment of investment account holders (IAHs) as stakeholders, enhancing transparency in ﬁnancial disclosure, and standardization. This will require active participation in the debate and formulation of the new regulatory environment at local and international forums.
The real challenge will be the enforceability of new rules and standards. Islamic ﬁnancial institutions are mostly operating in dual-system set-ups, which impose additional responsibilities on the regulators to maintain regu- latory and supervisory standards for both conventional and Islamic institu- tions. This practice is resource intensive as well as expensive. With stricter standards, the challenge will be to ensure that Islamic ﬁnancial institutions get due attention and priority in this process. At present, regulatory and supervisory standards, including compliance with Basel II, are being devel- oped for Islamic ﬁnancial institutions, though their enforceability is in ques- tion. Since the majority of Islamic ﬁnancial institutions operate in developing economies, it requires extra effort to enforce the standards irrespective of how good or bad they are.
Islamic ﬁnancial institutions are perceived to have higher exposure to operational risk due to the lack of proper risk systems and trained staff. In the new ﬁnancial environment, there will be more reliance on risk monitor- ing and management. New techniques for monitoring credit and liquidity risk will be introduced, and old techniques such as value-at-risk will be reﬁned to reﬂect better exposures. Islamic ﬁnancial institutions should start thinking about addressing this issue by updating their risk systems. At the same time, regulatory bodies are required to devise proper training for their staff as well as for ﬁnancial institutions. Regulators and supervisors should also develop a better understanding of certain practices of the ﬁnancial insti- tutions in assessing and monitoring risks.
The ﬁnancial crisis of 2007–09 has also been attributed to ﬁnancial engineering, resulting from the introduction of complex and risky assets. While ﬁnancial engineering will survive as both an art and a ﬁnancial tool, it will become the subject of much closer scrutiny, with market and regulatory forces imposing new ethical and moral elements in its evolution and practice going forward.
For the Islamic ﬁnancial industry, ﬁnancial engineering is vital. Iqbal (1999), Iqbal and Mirakhor (2007), and Askari et. al. (2008) have repeatedly argued for the role of ﬁnancial engineering in Islamic ﬁnance. Al-Suwailem (2006) lays down four principles for ﬁnancial engineering from an Islamic perspective. First, the “principle of balance” asks for an integrated and bal- anced approach where all aspects of economic and social values—such as justice inclusiveness, cooperation, and competition—are considered. Sec- ond, he advocates the “principle of acceptability,” that all economic dealings are generally acceptable unless otherwise stated by Shari’ah. This principle, linked to freedom of contract in Islam, has been the cornerstone for inno- vation in Islamic history.
Third, the “principle of integration” states that an integrated real and ﬁnancial sector are essential for sustainable growth; therefore, the foremost objective of any innovation should be to enhance integration between the two sectors. Finally, the “principle of consistency” states that the form and substance of Islamic products must be consistent with each other—that is, form should serve substance, and means should conform to ends.
The challenge of ﬁnancial engineering is serious and should be met seriously. For Islamic ﬁnancial institutions, a ﬁnancial engineering challenge is to introduce new Shari’ah-compatible products that develop much-needed money and capital markets and enhance liquidity, risk management, and portfolio diversiﬁcation.
Generally, attempts to apply ﬁnancial engineering techniques to Islamic banking will require the commitment of a great deal of resources to understanding the risk–return characteristics of each building block of the system and building new products with different risk–return proﬁles that meet the demands of investors, ﬁnancial intermediaries, and entrepreneurs for liquidity and safety.
The practice of reverse engineering—or imitating, or attempting to repli- cate a conventional security—should be discouraged if and when such a prac- tice means cutting corners and compromising the essence of the principles of Islam. The Islamic ﬁnancial industry and policy makers should encourage the application of ﬁnancial engineering to develop and introduce new prod- ucts with their own distinct risk–return proﬁles. Given the current state of affairs, ﬁnancial engineering should be targeted to the following areas:
- The current ﬁnancial crisis has exposed all major ﬁnancial institutions, as well as ﬁnancial markets, to liquidity risk. Liquidity risk is higher in Islamic ﬁnancial markets due to the lack of liquidity-enhancing prod- ucts; therefore, liquidity management qualiﬁes to be the ﬁrst candidate for ﬁnancial engineering. There is a need to develop products to estab- lish a vibrant intra-bank market and to cater for different maturity structures.
Key Considerations in Developing an Islamic Financial System 167
- The market for sukuk was hit from two sides in 2008—ﬁrst, by objec- tions raised by some Shari’ah scholars who questioned the authenticity of the structures and certain practices; and second, by the ﬁnancial cri- sis, which was triggered by securitized products. Financial engineering should introduce sukuk, which are truly asset-based and at the same time are based on transparent structures. The corporate debt market is driven by a vibrant government debt market, which serves as a bench- mark for other markets. In the case of Islamic ﬁnancial markets, there are very limited sovereign or government sukuk issuances available in the market. The public sector in countries serious about Islamic ﬁnance should apply ﬁnancial engineering to mobilize funds for that sector so that proper benchmarks are established.
- Risk management will continue to be a critical area. The use of deriva-
tives may slow down, but it will not be eliminated from the system. Products for sharing or transferring risk are very limited and, therefore, require the attention of ﬁnancial engineering.
One of the main features of an Islamic ﬁnancial system advocated by econo- mists is that there is a direct linkage between the real and the ﬁnancial sector of the economy.17 Through securitization, conventional ﬁnancial markets introduced the concept of “asset-based” securities, which have beneﬁted the markets enormously. The art of securitization introduced much-needed liquidity in the market, allowed the enhancement of yield, provided port- folio and risk management opportunities, and—even more importantly— developed a market-based, “collateralized,” low-risk security. The success of securitization can be judged by the fact that, before the advent of the sub- prime crisis, the spreads between Treasury yields, swaps markets, and secu- ritized assets had narrowed considerably. The main reason for such narrow spreads was that the security was considered to be backed by a real asset.
Despite these various beneﬁts, many blame innovative securitization itself for the ﬁnancial crisis. While we cannot deny the beneﬁts and positive contributions of securitization to the development of the ﬁnancial markets, the fault lies in making securitization too complex and remote from the real asset.
The Islamic ﬁnancial industry can learn from this episode and develop securitization, which has similar features to conventional securitization but is not remote from the underlying asset, is transparent, and is truly “asset-linked” as opposed to “asset-based.” The Islamic ﬁnancial industry also needs to learn from the current practice of securitization in the form of sukuk and their associated problems. One of the major criticisms of some of the existing sukuk structures is that, contrary to theoretical and Shari’ah
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