Delegates during East Africa Islamic Economy Summit last year. file photo | nmg
Today, as the global economy is experiencing its first green
shoots, one cannot forget the trauma of the economic winter precipitated
by the global financial crisis of 2007-2008, one of the worst in living
memory.
Following the crisis, many economists
revisited the perennial question as to whether ‘the seeds of these
recurrent crises lie in the systemic flaws in the financial system?’
A
number of studies have shown that Islamic banks did indeed weather the
financial storm better than their conventional counterparts exhibiting
lower hazard rates.
This is mainly attributed to the
higher levels of capital adequacy and liquidity of Islamic banks, prior
the crisis, laying the foundations for regulatory bodies such as Basel
Committee to proffer new amendments on additional capital adequacy
requirements and stress-measured liquidity.
This remedy is much akin to installing better ‘airbags in a car’ rather than prevention of the crash in the first place.
What
else might we assimilate from Islamic finance for the benefit of the
long- term financial stability of our economy? To answer this question,
we need to divulge into the three prohibitions in which Islamic finance
is premised upon: (i) interest, (ii) excessive speculation and (iii)
information asymmetry in contracts.
The most
conspicuous facet of Islamic finance is prohibition of the
interest/usury-based finance model. Experts would argue that the
burgeoning ethical finance industry falls short of addressing the
dominant issue of the inequity and unfairness inherent in the
interest-based financial model.
The potential
exploitative nature of interest-based finance in favour of ‘capital
owners’ and the evermore tenuous link between financial transactions and
the real economy create dire conditions for our economic system.
Islamic
banks were intrinsically constrained from investing in the abstract
financial products such as Collateral Debt Obligations (CDOs) and Credit
Default Swaps (CDSs) due to the prohibition of sale of debt concept in
Islamic finance and excessive speculation involved in these products.
Even
if sale of debt was allowed, the products would not have been
sanctioned on the grounds that their complex structures engender
information asymmetry between parties.
The specialised
knowledge required to unravel the complexity of mathematical models of
risk aggregation and pool tranching meant that even international credit
rating agencies had failed to understand properly the underlying risks;
hence they were appropriately termed by Warren Buffett as ‘financial
weapons of mass destruction’.
How does Islamic finance
work if it does not earn income from interest? Two main ways: (i)
financing contracts comprising of sale or lease of tangible assets and
(ii) partnership financing.
Whilst the borrower can
incur debt from transacting via sale contracts, the debt is
collateralised by a tangible asset and the profit margin is
pre-determined and fixed, avoiding the spiralling costs to the borrower
with the variance of time mitigating the likelihood of business
insolvency.
In the case of partnership financing, the
general format is Profit & Loss Sharing (PLS). The common PLS
structure creates more parity between those who own capital, and those
who employ ‘knowledge and skill’, normally the client, in a form of
partnership where both profits and loss are shared.
Implicitly,
the capital owners partake in the risk of the client’s financed
business. The internal dynamics of this structure embeds firmer risk
mitigation by virtue of the capital owner undertaking enhanced and
constant due diligence commensurate with additional risk assumed by
them.
In contrast to the normative models of finance
constituted on profit maximising proposition, Islamic finance is
predicated on the achievement of socio-economic well-being of all
segments of society.
It is therefore of no surprise
that Islamic finance has created a number of innovations to serve the
wider community for the furtherance of social goals such as endowment
trusts and microfinance.
The Islamic endowment funds –
that arguably inspired the development of endowment trusts in English
law - have played a pivotal role for centuries in aiding vulnerable and
disadvantaged persons and alleviating poverty levels in society.
The
endowment trust model has been instrumentally employed also to fund
other communal initiatives such as universities, libraries and museums.
Islamic
microfinance and SME financing has also been inherent facet of Islamic
finance offerings as it accomplishes the social responsibility of
Islamic finance institutions despite their higher risk.
In
one reputable Islamic bank, it apportions part of risk capital to fund
these riskier ventures despite lower returns as part of its community
responsibility mandate.
While Islamic finance does not
claim to be a panacea for all of the ills of the financial system, it
has the potential to answer the calls of some financial regulators who
harken a return to ‘back-to-basic’ banking to rebuild trust and greater
social justice in the banking system.
Farrukh Raza is Managing director Islamic Finance Advisory and Assurance Services.
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