Social Capital and Risk Sharing: An Islamic Finance Paradigm
SOCIAL CAPITAL AND RISK SHARING – Book Sample
Foreword – SOCIAL CAPITAL AND RISK SHARING
Financial markets have a role to play in promoting risk-taking through spreading the gains and losses among participants who may have differing risk-return profiles. For markets to function efficiently, it is important that market participants trust that the risks and rewards will be distributed fairly. If rewards are retained by a few while the risks are borne by many, confidence in the integrity of markets will be eroded.
The fragility of a debt-based system, which effectively transfers entire risks in interest transactions to the investors, has been amply demonstrated by the global financial crisis of 2007–2008. Indeed, risk transfer together with high leverage weakens the link between the financial and real sectors and can undermine the entire financial system. It stifles economic growth and leads to uncertainty, inequity, and the erosion of societal well-being.
In this context, Islamic finance with its paradigm of risk-sharing, mutuality, and fairness offers a distinctive value proposition and can form the basis of a financial system that offers clarity and absence of ambiguity, just and fair treatment for all participants, consideration for the rights of others, and the economic well-being of society.
Ethics and the public good are inherent in the Islamic concept of risk sharing. Thus Islam encourages trade and business partnerships while prohibiting interest transactions that shift the entire risk of the transactions from the capitalist to the entrepreneur. This is entirely consistent with the fundamental principles of the Shari’ah, which prohibit iba, leverage, speculative risk taking, and gharar as a means of realizing the ideals of social justice and preventing exploitation.
The concept of risk sharing advocated by the Shari’ah facilitates the integration of risk management with value creation. In a healthy venture, fear of loss works to counterbalance hope for gain, contrary to a system that permits the shifting of risk and which has the effect of inequitably relieving the risk seller from the fear of loss.
Risk sharing also promotes entrepreneurship. The ability of project promoters to share the risks of their business equitably with willing investors will encourage the emergence of more entrepreneurs, thus contributing to real economic growth and wealth creation.
At the same time risk sharing fosters strong commitments, greater self and market discipline that can effectively address any violation of the applicable arrangements, thus facili- tating competitiveness and profit maximization, while promoting ethical and responsible conduct and the attainment of the public good.
This equitable principle of shared risks and shared profits and losses in economic transactions can help to further unlock the virtues of Islamic finance. Public good, ethics, shared values, governance, real and tangible contributions to the economy hold the key to innovation and growth.
The pursuit of profits guided by a higher social purpose will create not just eco- nomic returns but also comply with universal values shared by all of man- kind. Indeed, it is possible to derive profits from doing good and ensuring that this principle is practiced is key to strengthening the universality and acceptability of Islamic finance.
This book explores the various facets of risk sharing in Islamic finance and the various forms of capital that underpin it. Physical and economic capital development includes the optimal allocation of resources in line with economic needs, enhanced financial sector productivity and market effi- ciency.
These are complemented by human capital in the form of a diverse and strong pool of intermediaries together with empowered consumers and educated investors. Political and “regulatory” capital such as responsible thought leadership, robust legal, regulatory and supervisory framework, appropriate fiscal and monetary policies, and risk management practices are equally important factors in facilitating the development of Islamic finance. The important role that social capital (including moral capital) plays in reducing uncertainty by setting behavioral boundaries on human reactions to changing circumstances is examined at length. The role of social capital as an inherent enabler of risk sharing has assumed increasing importance in the aftermath of the global financial crisis which has underscored the significance of governance, values, trust, and confidence in the financial system.
This book also establishes a link between social capital and risk sharing,
both of which are the essence of the Shari’ah, and describes systematically how they can reinforce each other in the context of the development of Islamic finance. At a time when trust, ethics, and morality are in deficit, it is rightfully noted that the future stability of the financial system and the well-being of society will hinge on the restoration of trust, rebuilding of social capital, and strengthening of institutions.
The building of social capital as one of the moral solutions to the problem of inequality is suggested to enable the current economy to transform into the ideal economic system envisioned by Islam.
The authors also examine the role of trust and ethical behavior in stock market development and proposed several policy initiatives ranging from the construction of trust indices to the creation of a multiple reputational intermediary system and an industry social capital and ethics board.
Indeed, these are recommendations that warrant serious consideration given that the equity market is a significant component of the Islamic capital markets, facilitating the offering of Islamic finance products to serve the demand of global investors, and offering Islamic financial institutions potentially vast business opportunities.
Three forms of risk sharing activities—equity crowdfunding, macro-market participation instruments and waqf social impact partnerships—are also discussed, offering insights for further devel- opment of the Islamic finance industry. The line of enquiry initiated by this book could be pursued to elaborate further on the implementation of the risk-sharing paradigm.
At the macrolevel, Islamic finance exists in a broader socioeconomic framework for which compliance with the rules of the framework is essential. In fact, it is the framework that defines the direction and success of Islamic finance as a means of promoting moral, social, and economic devel- opment. The vision of Islamic finance should be embedded in the vision of the Qur’an. Muslim societies would need to understand and strive toward achieving this vision. The drive for material gains must be guided by the boundaries of behavior prescribed by the Qur’an
Rules of behavior, distributive justice, stock market development, eco- nomic growth, and finance have been interlaced into articulation of a critical perspective of the nature, effects, and purposes of social capital and risk sharing to make this a unique work. This book is a welcome addition to the literature on Islamic finance.
Risk Sharing and Social Impact Partnerships
Sari’ah scholars and Muslim economists who participated in the Second Strategic Roundtable Discussion (September 20, 2012, Kuala Lumpur) sponsored by the International Shari’ah Research Academy
for Islamic Finance (ISRA), the Islamic Research and Training Institute of the Islamic Development Bank Group (IRTI), and Durham University adopted a final statement known as the Kuala Lumpur Declaration. The statement argued that risk sharing is the essence of Islamic finance. It rec- ommended that (i) governments must endeavor to enhance risk-sharing systems by levelling the playing field between equity and debt; (ii) design fiscal and monetary policies based on risk sharing; (iii) issue macro-market instruments that are of low denominations, sold on the retail market and supported by strong governance oversight; and (iv) broaden the organizational structures beyond traditional banking models to formats such as venture capital and waqf to meet the social goals and risk sharing features of Islamic finance.
Effectively, the adoption and implementation of these recommendations can further strengthen social solidarity and cooperation, promote better governance, and build trust in the economic and social system. This chapter focuses on the design and development of risk-sharing instruments pursuant to the third and fourth recommendations of the Kuala Lumpur Declaration.
With regard to macro-market instruments, this chapter high- lights their benefits to the society and the economy, followed by a discussion on the mechanisms and ways in which these instruments can be developed.
On the broadening of structures beyond traditional banking models, this chapter draws insights from the development of social impact partnerships in the United Kingdom and the United States and discusses its relevance to the Islamic finance industry and the waqf sector. The over- all thesis is that macro-market participation instruments and social impact partnerships are closely aligned with risk sharing and promote social causes to the extent that they can strengthen social capital in the community.
Financing Government’s Budget through Macro-market Participation Instruments
A study by Reinhart and Rogoff (2009) suggested that all “currency” or “banking” crises of the past have been, at their core, debt crises. In a more recent study of 44 countries over a 200-year period, Reinhart and Rogoff (2010) concluded that the growth of economies comes under stress when debt-to-GDP ratio is above 30 percent. As the ratio surpasses 90 percent and goes beyond 100 percent, economic growth suffers significantly and an economy can grow to an extent that only allows it to service its debt.
While some methodological questions have been raised on this taxonomy of this study, the overall thesis of Reinhart and Rogoff that large debt creates a drag on the economy remains valid. With the stock of debt sig- nificantly larger than GDP and the rate of growth of GDP far less than the rate of interest, it is difficult to envisage how the world’s productive capacity can validate this mountain of debt and prevent debt-induced crises.
Recently, Thomas Piketty (2014) has drawn attention to the disastrous consequences of the dynamics of sizable positive differences between the rate of interest and the growth of GDP for income and wealth inequalities. It has long been known that large inequality erodes social solidarity, trust, and social capital. Growth in household debt is no less damaging than the growth of government debt.
Drawing on evidence from the United States and international data, Atif Mian and Amir Sufi (2014) reveal in House of Debt that “economic disasters are almost always preceded by a large increase in household debt” (p. 17).
A heavily debt-based finan- cial system concentrates risk and losses on the debtors and homeowners, resulting in spending cuts and unemployment. The previous and current policies have been heavily biased toward protecting banks and creditors, which have dramatically increased the flow of credit that brings with it disastrous counterproductive consequences.
These risk transfer and risk- shifting policies with interest rate-based instruments erode the fabric of the economy and weaken the social capital of society, resulting in financial regime uncertainty and loss of collective welfare. The search is on for an alternative in which risk sharing can serve as an efficient replacement r
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