Lecture Three: †††Problems and Prospects of Islamic Banking and Finance
at the Center for Near Eastern Studies,
†††††† During the last few decades of the twentieth century, the period in which Islamic banking and financial institutions were evolving, great changes were taking place in the financial environment. In this lecture I will examine the problems and prospects of Islamic banking in the perspective of these changes. Two changes are most significant, decline in intermediation and resort to more active, rather aggressive management of investment, and world-wide integration of financial markets in the wake of globalization.
††† The first trend, symbolized by the repeal
of Glass-Steagal in the
††† The problem is, investment management in modern conditions boils down to risk management which is very underdeveloped in Islamic financial theory and practice. Add to this the fact that, in Islamic perception, this is one of the areas of conventional finance in need of drastic reforms. This need was recently underlined by the story of Long Term Capital Management (LTCM ), ( told by Roger Lowenstein in his book, When Genius Failed, Random House, 2000 ). So we face a double challenge, to develop Islamic techniques of risk management and to see that these new techniques are free from the ills with which conventional methods are suffering. This is different from the challenge faced in the middle of twentieth century, to develop a method of financial intermediation free of interest.
† The task is stupendous. Mastery of risk may be regarded as the unique feature distinguishing the modern times. Some one has rightly remarked that elimination of risk has stolen the center stage from the elimination of scarcity† as a major preoccupation.
†† Risk was always there, especially in business. But industrialization brought risks unknown in trade and agriculture. Industrial production often involves long periods of time .The longer the period of production the more the uncertainty. The scope of the market has expanded to cover the whole world, introducing new kinds of risk. More than a thousand years ago, when Islamic laws were being written, the nature and scope of risk and uncertainty was different. However, something can still be learnt which, in combination with the modern experience, should enable us to realize the Shariah objectives of justice, fairness and efficiency.
††† The Prophet is reported to have prohibited the sale of an unborn calf, i.e. one still in its motherís womb. He is also reported to have prohibited sale of fish still in the pond. In both cases the reason is the uncertainty surrounding the quality and/or the quantity of the commodity being sold. Also, note that it was possible to remove the uncertainty involved to ensure fair dealing without killing the deal itself or causing unbearable inconvenience.
††† The Prophet is reported to have permitted the sale of fruits still on the trees and yet to ripe, despite the uncertainty as to quantity and/or quality present. It was not possible to wait till the fruits were fully ripe and were plucked and weighed or counted. That would leave no time for marketing.
†††† The Prophet is reported to have prohibited the sale of a non- existent commodity. But he did allow salam, sale of an agricultural produce months ahead of the crop, provided the price was paid in advance at the time of contract. This was found to be advantageous to the farmer as well as the grain trader, hence the uncertainty present was tolerated for a purpose.
† The message seems to be clear. Transactions need be based on complete information, as far as possible, in order to ensure neither party is under any illusion. But, given mutual consent, some uncertainty can be tolerated in order to secure larger advantages.
†† As to be expected, the juristic discussion of gharar (hazard, uncertainty) or transactions in absence of complete information is full of controversies. Some would care more for fairness and, hence, try to discourage transactions in situations of incomplete information. Others would give more importance to allow people enter deals they perceive to be mutually advantageous. I do not propose to enter into the details in the limited time available. I would rather draw attention to what exactly is involved in terms of human needs and interests in situations in which contracts must cover the future in order for life to go on efficiently.
† Risk, Speculation and Gambling
† It is important, at this stage, to distinguish gambling, which must be avoided, and other kinds of risk taking. In the words of Irving Fisher, a gambler seeks and makes risk which it is not necessary to assume. All games of chance are of this nature. But life is full of risky situations which cannot be avoided. Business specially involves risk because production of wealth as well as some other transactions involve the future, and it is not possible to have full and certain information regarding the future. People arrive at ways to face these uncertainties that are mutually advantageous. We try to understand this through some examples.
† A farmer sells future contracts of grain in order to protect himself from a fall in price, whereas a food processor buys future grain contracts in order to protect himself from a rise in prices. Both benefit. Even though each one is taking some risk, total risk is now less and both can go ahead with their production plans on the basis of agreed prices. Another example is oil futures sold by oil companies and purchased by airlines. Without these contracts possible fluctuations in oil prices would make future planning in† both industries almost impossible.
† Since direct deals between farmers and food processors or oil companies and airlines would be cumbersome and costly, it is efficient to have middlemen/intermediaries. Some sort of clearing arrangements soon follow. In short we have a new market for commodity futures. There is a role in this market for speculators. They do not, like gamblers, create or invite the risks they are dealing with. These are business risks which had to fall some where. Speculators take these risks, pool them, repackage them into† parcels† more acceptable to some in terms of quantity, quality, time involved, etc. Speculators take risks in order to make a profit thereby. They specialize in transferring risks to those willing to take them. They also allocate risk over time. Future markets have decisive impact on spot markets, making them more stable.
† Current research in these matters, and on the subject of risk management in Islamic framework in general, is inconclusive. The position is the same when we consider the currency markets. Contractors need different currencies at different points of time in order to fulfill production plans extending far into future and involving inputs from several currency areas. To make a commitment to do a job like delivering an aircraft or a shopping complex or an airport at a price denominated† in a single currency† at the time of the contract, the firm doing the project has to ensure that requisite amounts of other currencies are available at the proper time to buy the inputs needed. This involves buying foreign currencies in advance, something not permitted in Islamic law as interpreted at the present. Some scholars do, however, find a way through binding promises doing the job of actual contracts.
†† Current methods of dealing with uncertainties in the financial markets involve dealing in derivatives. These are innovations with little by way of precedents in the past. Some Islamic scholars find the old practice of urboon, i.e. depositing a small fraction of price in a deal to be concluded in the future, capable of justifying some kind of options which are the simplest kind of derivatives. This could be the first step towards a broad range of derivatives, some of them based on futures.
† Financial† Markets
†† It is time to wind up this discussion of financial markets in Islamic framework with a synoptic view of the situation. If we classify financial transactions into:
†Money for money
†Money for equity
†Money for debt
†Debt for equity
†Debt for debt
Equity for equity
Prohibition of interest seems to affect all the three markets into which debt figures, insofar as debt can be traded only at par. Money for equity poses no problems. Nor does the swapping of equity for equity. I have already noted the problem relating to the currency market. The overall conclusion is that financial markets under Islam will be smaller as compared to their size in an interest based regime, all other things remaining the same.
Islamic economists think it will be good for society. The ballooning of the financial sector out of all proportions with the real economy has undesirable consequences for the distribution of income and wealth. It also makes it amenable to gambling like speculation.
† But a too restrictive approach on part of Islamic scholars in the name of minimizing gharar (hazard, uncertainty ) and† blocking the road to riba (sadd zariah ) runs the greater risk of stifling genuine economic activity by reducing the amount of liquidity available on the one hand and increasing the total amount of risk on the other hand. The overall result could be Muslim societies run in accordance with these restrictive interpretations of Shariah lagging behind in economic progress and losing out to others, eventually, politically and culturally also. Instead of being the heralders of a more just, more stable and more efficient financial regime they would then serve only as a warning against a religious and moral approach to money, banking and finance. That would be a disaster that needs not be. It is hoped the new generation of Islamic economists will rise to the challenge posed by this situation.
is the second change I mentioned in the beginning. Financial markets the world
over are integrated as never before. Money moves across national boundaries without
cost and instantaneously. The few remaining exceptions are on the way out. In
principle this change should be favorable to Islam which never cared much for
national boundaries. In practice however it does pose problems for Islamic
financial movement, for two different reasons. Firstly the home base of this
new trend is the
† Globalization has increased the volatility of almost every financial variable, especially the exchange rates. It has also reduced the efficacy of national economic macro-management. The redress can only come through international agreements curbing speculation and regulating the financial markets. The insights of the Islamic financial movement relating to sharing modes of finance, commodity-linked financing like murabaha, and reducing the role of debt have great potential in this regard.†
Prospects at the State Level
There is a lull in the state sponsored Islamic finance.
† Meanwhile progress has been made in the regulation of Islamic financial institutions† by their respective† national authorities in view of the increasing market share† of these institutions. There is better understanding of Islamic finance by the monetary authorities and closer cooperation between them and these institutions, sometimes with the involvement of the Islamic Development Bank.
†Efforts to standardize Islamic financial products continue. The standards developed by the Accounting and Auditing Organization of Islamic Financial Institutions are being adopted. The need to standardize such basic elements of Islamic finance as mudaraba, murabaha and ijara is widely felt as the present lack of uniformity is baffling. There are moves to coordinate the activities of the various Shariah advisory boards of Islamic financial institutions as the way they function remains a source of confusion.
† There is a big information deficit in the Islamic financial industry hampering its further growth and development. The absence of† rating agencies, specially agencies that would rate products as well as institutions on the ground of their Shariah compliance, is the biggest example of this deficit.
† Despite odds, the industry continues to grow, especially in the Gulf countries. It has also reached the newly independent Central Asian Islamic Republics and the Balkans. But the weak economic conditions in those countries are naturally reflected in the state of their nascent Islamic financial institutions.
† Prospects at the Grass Roots and the Community Level
The youngest Islamic financial institutions are found outside Muslim majority areas, in the Americas, Europe and India. Many of them have successfully completed their first decade of operations. All of them are growing in size. They serve their respective communities in interest free house finance and installment purchase of consumer durables, as well as in investing their savings on the basis of profit sharing. The possibilities of expansion are great.
†Research and Development
† All innovations need a base in research and development, which in turn draw on fundamental research in universities and laboratories. Islamic finance became a subject of research in universities in 1980s. The subject is discussed every year at high profile conferences in Bahrain, Harvard, and other places. Yet the resources devoted and the facilities available hardly match the challenges facing the industry.
† As the Bank of International Settlements has noted, innovations in three directions are crucial: liquidity enhancement, risk transfer and revenue generation. In its early days Islamic finance had to focus on revenue generation as it had to compete with conventional finance and show comparable returns. Times have changed. The need to enhance liquidity, and hence to move towards greater securitization of assets, is already recognized as evidenced by the developments in Malaysia. The bottleneck at the present seems to be risk management.
†Another important area† awaiting innovative initiatives is a vision that encompasses Zakat( obligatory charity ) Waqf( charitable endowments ) and Islamic financial management. Securitazation can help mobilize the huge wealth locked into awqaf properties which in their turn can be developed by investment of zakat funds awaiting distribution. At the present only a small fraction of the liquidity generated by zakat passes through Islamic financial institutions, a situation reflecting the distance between the poor, non-banking population and these institutions.
†The goal of progress with justice and equity inspires the entire humanity and there is no reason the potential of Islamic financial institutions contributing towards the realization of this goal remain unexploited. In the age of globalization no system that serves only the interests of a particular country or group of countries can evoke universal acceptability. Protection of small countries from speculators chasing instantaneous profits, reduction of the role of debt in international finance and financing projects helpful in reducing poverty and inequality deserve every ones attention.