Globalization and Islamic Finance

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.

 Financial engineering

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.

Transparent securitization

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