Risk sharing in finance: the Islamic finance alternative
||Risk Sharing In Finance|
||Hossein Askari, Noureddine Krichene, Zamir Iqbal|
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RISK SHARING IN FINANCE – Book Sample
The Role of Institutions and Governance in Risk Sharing
Informational and agency problems have been discussed in the context of one risk–reward-sharing instrument, namely equity. On the one hand, for example, Stiglitz (1989) suggests that there are two informational problems in the case of equities: (i) an adverse signaling effect, which deters good ﬁrms from issuing equity for fear that it may signal poor quality; and (ii) an adverse incentive effect, which suggests that equity ﬁnance weakens the incentive for entrepreneurs or managers (agents) to exert their maximum effort for the highest maximum joint returns for themselves and their shareholders (principals).
This happens because once the project is ﬁnanced, the entrepreneur knows that the net return will have to be shared with the ﬁnancier (the principal) and, therefore, may not have a strong motivation to work as hard as when the return is not shared. On the other hand, there are agency and informational problems in interest rate-based debt ﬁnancing. Stiglitz points out that there is an inherent agency conﬂict in debt ﬁnanc- ing in that the entrepreneur (the agent) is interested in the high end of the risk–return distribution. The lender (the principal), on the other hand, who is interested in safety, focuses on the low end of the risk–return distribution, and therefore discourages risk taking. This, Stiglitz asserts, has “deleterious consequences for the economy.”
He further suggests that “from a social point of view equity has a distinct advantage: because risks are shared between the entrepreneur and the capital provider, the ﬁrm will not cut back produc- tion as much as it would with debt ﬁnancing if there is [a] downturn in the economy.” Moreover, we would add that in the case of an economic or ﬁnancial crisis, a heavily debt-ﬁnanced corporation may face withdrawal of short-term debt that could place its very existence in jeopardy, whereas an equity-ﬁnanced company does not face such short-term withdrawals.
The agency problem has been generalized to bank lending. Banks, being highly leveraged institutions that borrow short (deposits) and lend long, are exposed to an asset–liability mismatch that creates potential for liquid- ity shocks and instability. Stiglitz suggests that to protect their ﬁnancial resources, banks are generally discouraged from risk taking.
Additionally, their behavior toward risk often creates informational problems that lead to phenomena that can be classiﬁed as market failure, such as credit rationing. In contrast to Stiglitz’s position, Hellwig (1998) argues that there is an oft- neglected informational problem in the lending behavior of banks, which he refers to as “negative incentive effects on the choice of risk inherent in the moral hazard of riskiness of the lending strategy of banks.” This risk mate- rialized dramatically in the period of run up to the recent ﬁnancial crisis (see Askari et al., 2010; Sheng, 2009).
Based on the above background, the central question is whether Islamic contracting (based on risk sharing and thus, in turn, equity ﬁnance) is better suited to solving this contractual dilemma under conditions that promote risk–reward sharing and prohibit interest-based debt ﬁnancing.
In the presence of informational problems such as asymmetric information (where only one side of the contract, usually the agent, has information not available to the other parties), there is transaction cost as well as cost of monitoring the agent’s activities and the project(s) performance. It could be plausibly argued that in Islamic contracts asymmetric information issues would be minimized.
This assertion is supported by the strict rules governing contracts, exchange, and trade enunciated in the Qur’an and in the Tradition of the Prophet (pbuh). These rules include the need for written contracts that fully and transparently stipulate terms and conditions, the direct and unequivocal admonition that commitments to the terms and conditions of contracts must be faithfully carried out, and strong emphasis on trust, cooperation, and consultation. Rules governing market behavior also create incentives—both positive and negative—to enforce honest, transparent, and compliant behavior on the part of participants. Hence, risk-sharing contracts designed under Islamic rules would mitigate informational problems (Khan and Mirakhor, 1987; Ul-Haque and Mirakhor, 1987; Presley and Sessions, 1994) and could be better structured than interest-based debt contracts with incentives to maximize both parties’ expected joint rewards.
However, human nature being what it is, the rules of behavior established centuries ago are more likely to be followed if they are enforced. This requires the creation of ﬁnancial and economic institutions that are based on and governed by Islamic teachings on economics, ﬁnance, and appropriate human behavior in business and ﬁnancial dealings. In this chapter, we discuss the key institutions of Islam, which play a critical role in the economic system. We also discuss the required governance principles for developing economic institutions.
SIGNIFICANCE OF INSTITUTIONS AND THEIR DEVELOPMENT
Research has conﬁrmed the critical role and importance of well-established and efﬁcient institutions in the economic and social development of countries. Over the last 30 or so years, there has been a sea change in economic development theory. Whereas earlier economists used to stress the availability of national savings, foreign exchange earnings, and technology, today the foundation of sustained and rapid economic development is seen as good institutions, with education being the other critical element. Because of the distinct characteristics of ﬁnancial contracts, the need for effective institutions in ﬁnancial markets is most critical (Fergusson, 2006). As the ﬁnancial markets grow, the signiﬁcance of an appropriate legal framework and adequate enforcement of the rights and constraints (the “rule of law”) of all the par- ties involved in the contract also grows.
Beck and Levine (2003) show that the level of ﬁnancial development is higher in countries where legal systems enforce private contracts and property rights, and where creditor rights are protected. If that is not the case, typical problems of moral hazard, adverse selection, and time inconsistency due to informational asymmetries can affect the smooth enforcement of contracts, and many of these problems can be mitigated through well-designed contracts and proper “institutions” (Fergusson, 2006). More simply stated, if ﬁnancial markets and regulations are not well designed and rules of behavior are not supervised and enforced, individuals and corporations would be less likely to enter into ﬁnancial contracts.
Fergusson undertook a detailed survey of the literature concerning the development of institutions and legal frameworks, and of their linkage with ﬁnancial development. A condensed version of his main arguments and relevant empirical evidence is given in Table 10.1.
KEY ECONOMIC INSTITUTIONS OF ISLAM
An economic system is a collection of institutions set up by society to facilitate the allocation of resources, production and exchange of goods and services, and distribution of the resulting income and wealth, according to the society’s social and moral priorities. What has been said can be directly applied to Islam with only a single exception—that is, instead of the word “society” in the deﬁnition of an economic system, we insert the words “the Law-Giver,” to have a deﬁnition for an Islamic economic system as:
. . . a collection of institutions, i.e., formal and informal rules of conduct and their enforcement characteristics, designed by the Law-
Giver, i.e., Allah (swt) through the rules prescribed in the Quran,
CORPORATE GOVERNANCE FRAMEWORK IN ISLAM
The issue of corporate governance and the search for an optimal governance structure has received considerable attention in the conventional economics literature and in public policy debates. This increased attention can be attrib- uted to several factors, such as: (a) the growth of institutional investors (pension funds, insurance companies, mutual funds, and highly leveraged institutions), and the role they play in the ﬁnancial sector, especially in the major industrial economies; (b) widely articulated concerns and criticisms that the current monitoring and control of publicly held corporations in Anglo-Saxon countries, especially the UK and the US, are seriously defec- tive, leading to sub-optimal economic and social development (Kasey et al., 1997); (c) a shift away from a traditional “shareholder-value centered” view of corporate governance toward a corporate governance structure extended to a wide circle of stakeholders; and (d) the impact of the increased globaliza- tion of ﬁnancial markets, the global trend toward the deregulation of ﬁnancial sectors, and the liberalization of the activities of institutional investors, which have raised concerns over corporate governance.12 Although each of the above- mentioned factors provides compelling reasons to examine corporate-gover- nance structures, the current ﬁnancial crisis has unearthed new governance issues, some of which were either ignored, or not taken seriously, or were never even discussed earlier.
Iqbal and Mirakhor (2002) developed a stakeholder-based framework
of corporate governance in Islam. Key principles of Islam’s perspective on governance can be understood in the light of its teachings on property rights, contracts, trust, and ethics, and are summarized below.13
Preservation of the property rights of all members of society is essential in governance. The axioms of property rights as described earlier laid the foundation for good governance, which advocates that the rights of each member of society should be preserved over physical property, and that any misuse and misappropriation of others’ rights should not be allowed. Business leaders and the holders of public ofﬁce have an additional responsibility to ensure that the rights and responsibilities attached to the property given to them in trust are discharged according to their best ability and that the utmost care is taken in discharging this duty.
Whereas Shari’ah guarantees some basic property rights to individuals by virtue of them being members of society, the rights of a ﬁrm or a legal entity such as a corporation are earned and acquired. It is not the ﬁrm itself that accrues property rights, but the property acquired in the course of the ﬁrm’s economic activity that has property rights and claims vested in it.
Once a property is earned or acquired by the ﬁrm, it is subject to the same rules of sharing and the prohibition of waste as apply to the property of individuals. A ﬁrm’s property rights also come with similar claims and responsibilities such that the ﬁrm is expected to preserve the property rights of the local community or society but also those of the people who have participated in the process of acquiring or earning the ﬁrm’s property. No action of the ﬁrm that violates the basic property rights of those with whom it interacts is acceptable.
The great emphasis placed on contracts for governance in Islam is to make individuals and economic agents aware of the obligations arising from their contractual agreements—verbal or written, explicit or implicit. In the case of explicit contracts, parties to the contract clearly stipulate the behavior and duties expected with respect to the terms of the contract. This contract is to be free of information asymmetry; parties intend to comply with the terms of the contract and are fully aware of their rights and obligations. Importantly, the state ensures the enforceability of the contract if either party violates the terms. On the other hand, implicit contracts are not formal contracts with clearly deﬁned terms but are claims and obligations that come with the right to be part of a society.
Principles of sharing and the rights of collectivity to property rights are forms of implicit contracts which serve to preserve and protect the rights of others and thus establish a wide spectrum of implicit obligations. Within the property-rights framework, one has contractual obligations to others, including the community and society, according to the rules of Shari’ah, and the honoring of this obligation is considered a sacred duty. This sacred duty to preserve the property rights of others is the moral, social, and legal foundation for recognizing and enforcing obligations to explicit and implicit contracts. As such, it is one of the founding principles of the governance framework in Islam.
The Role of Institutions and Governance in Risk Sharing 217
Trust brings responsibility and accountability. The Qur’an makes trust and trustworthiness, as well as keeping faith with contracts and promises, obligatory and inviolable except in the event of an explicitly permissible justiﬁcation (Iqbal and Mirakhor, 2007; Habachy, 1962). Trust is important social capital, which plays a vital role in promoting good governance, especially in the case of institutions dealing with ﬁnancial services, which are given property to manage in “trust.” Therefore, preserving high trust should be an integral part of the governance goals of business leaders and the holders of public ofﬁce.
Islam demands high standards of ethical and moral behavior from every- one in society, but emphasizes these standards for those who govern or represent others in society. Islam expects excellence in moral values, truth- fulness, and virtuous conduct from every member of society, particularly those who are involved in business.14 For example, the Qur’an (3:110) says: “You are the best nation that has been raised up for mankind; you enjoin right conduct [rule compliance], forbid evil [rule violation] and believe in Allah (swt).” Also, there are several sayings of the Prophet (pbuh) to emphasise the signiﬁcance of high morals and good conduct, such as the following:
I have been sent for the purpose of perfecting good morals.
—Ibn Hambal (No. 8595)
The truthful merchant [is rewarded by being ranked] on the Day of Resurrection with prophets, veracious souls, martyrs and pious people.
—Tirmidhi (No. 1130)
Within the framework of economic justice, emphasis is placed on being mindful to give full measure and weight in all business transactions. The verses which state “Woe unto those who give short measure, those who, when they are to receive their due from [other] people, demand that it be given in full but when they have to measure or weigh whatever they owe to others, give less than what is due!” (83:1–3) remind individuals against any negligence or cheating in determining what is owed to others. They refer not only to commercial dealings, but also encompass every aspect of social rela- tions, both practical and moral, and apply to every individual’s rights and obligations no less than to his or her physical possessions (Asad, 2004).
The governance framework is inclusive of a broad range of stakeholders. The principles governing property rights and contracts in Islam clearly justify the inclusion of stakeholders in the decision-making and governance structure.
This inclusion is based on the principles that (a) the collectivity (community, society, state) shares the rights in the property acquired by either individuals or ﬁrms; (b) the exercising of property rights should not lead to any harm or damage to the property of others (including stakeholders); (c) the rights of others are considered as property and are therefore subject to the rules regarding the violation of property rights; and (d) any property leading to the denial of any valid claim or right by any member of society would not qualify to be recognized as al mal and, therefore, would be considered unlawful according to Shari’ah.
Finally, the obligations accruing from explicit and implicit contracts broaden the range of stakeholders eligible for inclusion in the governance framework.
In the absence of rule compliance (that is, in a weak institutional environment), risk-sharing contracts require enhanced monitoring and a strengthened governance regulatory apparatus. The same principles of governance under which an individual or a ruler or a state should function apply also to ﬁrms. Iqbal and Mirakhor (2004) argue that within the Islamic framework a ﬁrm can be viewed as a “nexus of contracts” whose objective is to minimize transaction costs and maximize proﬁts and returns to investors subject to constraints that these objectives do not violate the property rights of any party, whether it interacts with the ﬁrm directly or indirectly.
In pursuit of these goals, the ﬁrm honors all implicit or explicit contractual obligations. As could be discerned from the discussions on contracts and trust, it is incumbent on individuals to preserve the sanctity of implicit contractual obligations no less than those of explicit contracts. By the same token, ﬁrms have to preserve the sanctity of implicit and explicit contractual obligations by recognizing and protecting the property rights of stakeholders, the community, society, and the state. Since the ﬁrm’s behavior is shaped by that of its managers, it becomes their ﬁduciary duty to manage the ﬁrm as a trust for all stakeholders in ensuring that the behavior of the ﬁrm conforms to the rules and norms speciﬁed by the law (Iqbal and Mirakhor, 2011).
In sum, the governance framework, as deﬁned by the principles of Islam, is focused on achieving the promotion of social justice, unity, and social cohesiveness; the curbing of counterproductive behavior such as greed, deceit, misrepresentation, and the misappropriation of property; a strong commitment to contractual obligations; establishment of trust; and trans- parency in decision making. The governance framework must be inclusive of the participation of all stakeholders in the decision-making process.
VI. SIGNIFICANCE OF ENHANCED MONITORING AND GOVERNANCE
The nature of risk-sharing contracts requires enhanced monitoring and governance. Certain characteristics of governance such as ownership structure, ﬂow of ﬁnancial information, stakeholder rights, and board structure are intended to reduce moral hazard and adverse selection problems present in publicly traded ﬁrms.
Governance and a ﬁrm’s capital structure are closely related. Studies have examined the impact of corporate governance on the value of the ﬁrm and have found that ﬁrms with weaker corporate gover- nance mechanisms tend to have a higher debt level (Kumar, 2005). In the case of equity ﬁnancing, dispersed shareholdings can also have a negative impact on the effectiveness of governance, since it is expensive for individual inves- tors to monitor management activities on their own—a free rider problem (Skaife et al., 2004).
However, as a shareholder accumulates more shares, his or her incentives for monitoring increase. This poses challenges for design- ing a governance structure and a monitoring mechanism to protect the rights of all stakeholders irrespective of the extent or the degree of their stake in a company or a project. The stakeholders-oriented governance structure as advocated by Islam can reduce or eliminate such governance issues.
The quality of ﬁnancial information leading to greater disclosure and ﬁnancial transparency reduces information asymmetries between the ﬁrm and its shareholders. Availability of credible information enhances monitoring and governance.
Equity ﬁnancing comes with unconditional monitoring rights, but debt holders’ monitoring rights are contingent on the event of bankruptcy and depend on the implementation of a cost-effective and credible information ﬂow to outside investors (Buehlmaier, 2011). One way to overcome the agency problem associated with debt has been to increase covenants that restrict bor- rowers’ actions and indirectly grant control rights to the lender to reduce expo- sure to credit risk.
Financial intermediaries and banks specialize in information gathering on borrowers and thus rely on monitoring and long-term relation- ships. Availability of transparent information becomes vital in determining an entrepreneur’s preferred mode of ﬁnancing. For example, a ﬁrm with less publicly available information is more likely to depend on lending from ﬁnan- cial intermediaries such as banks at the expense of the ﬁrm’s management’s willingness to grant greater oversight to the ﬁnancial intermediary. However, a ﬁrm with wider access to publicly accessible information will prefer to bypass a bank and access the capital markets directly (Whitehead, 2009).
Enhancing the quality and the ﬂow of information is essential in
enhancing the transparency and monitoring aspect of governance, especially for risk-sharing ﬁnancial contracts. Access to information enables creditors to evaluate risk and the price of ﬁnancial securities. Islam’s emphasis on full
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