RISK MANAGEMENT IN AN ISLAMIC FRAMEWORK

 

mnsiddiqi@hotmail.com

15 February 2009

 

Introduction§

 

This Note tries to look at risk man faces in economic activity in general and in finance in particular. Economic prosperity and the efficiency and stability of our financial system depend on proper handling of risks. This is also true of justice and equity; they too require that risks be handled in ways favorable to building a just society.

Risk in economic activity emanates from lack of information, which in itself is often in consequence of involvement of future.

 

Most often one produces to sell. The longer the period of production the greater the uncertainty attaching to the selling price, generally speaking. Size of the market is also a factor. Globalization and integration of world markets has also increased risks. Uncertainty also attaches to the cost of production. These uncertainties make the expected profits uncertain. The profits may be high or low, they may even be negative, i. e. the producer entrepreneur may sustain losses. This is the major risk a producer takes.

 

The producer generally runs his business by funds provided by a financier. The financier wants his/her money back and demands some reward over and above the capital invested. Such a reward can come out of the profits accruing to the producer/entrepreneur. As the return of capital as well as the reward promised is, for practical purposes, linked to the results of the enterprise, the financier too is vulnerable to the risks of business noted above.

 

 Most often finance is provided to the entrepreneur not by the fund owner directly but by an institutional financial intermediary. The institutional financial intermediary collects investible funds from large number of savers and supplies them to businesses that want them. Funds supplied to the intermediary are generally for short periods whereas the fund users want them for longer periods. Credit intermediation and maturity transformation, though necessary for financial intermediation, carry risks. Sometimes financial intermediaries take other risks too, like accepting funds in one currency and making investments in another currency. But these risks, like the risks taken by producers, are worth taking as they bring great benefits to society by making possible production that is large scale and takes long periods of time.

 

Expansion of the real economy by larger production of goods and services requires expansion of the financial sector through greater mobilization of society’s savings and innovative methods of financing productive enterprises, exchange and distribution. With the expansion of the financial sector come more risks.

 

If each economic agent was left to bear the risks involved in his/her economic activity alone economic activity will be severely constrained. It is socially advantageous to allow economic agents to distribute the burden of risk bearing among themselves. The more widespread the dispersal of risks, the larger the volume of risks that can be borne by the society as a whole, hence the more efficient the system. But this must be done equitably. Fairness requires that those who bear losses in case there are losses also get  profits in case there are profits insofar as these losses/profits devolve on uncertainty. When risks are distributed in a manner that makes one category of economic agents more vulnerable to losses and another category of people more likely to gain in cases of profits, that particular scheme of distributing risks becomes anti social. If we allow speculators to buy risks using other peoples’ money (promising the ‘insured’ return of their capital with interest) the incidence of losses in case of heavy losses falls mainly on these other people whose money was behind the bet. Where as their ‘profits’ are confined to the fixed fees paid by the sellers of risk. Meanwhile the intermediaries earn their commissions from profits but pass on the entire loss to the fund owners. This seems to be what happened in case of Collateralized Debt Obligations (CDOs) and Credit Default Swaps (CDSs) in the US financial market recently. It seems prudent to confine the distribution of risk among those actually involved in production, exchange and distribution of goods and services and those willing to invest their savings in these enterprises. In other words, prudent risk distribution should exclude gamblers who want to bet on the possible outcomes of risky ventures. These bet makers do not supply more investible funds to the real sector. The funds at their disposal are used in the manner money is used in a casino: making a bet in expectation of a win, ready to lose the amount involved in the bet, with the crucial difference that the money lost belongs to other people!

 

 Risk Sharing versus Risk Transferring

 

If the financier agrees to a share of the profits as his/her reward, we describe this arrangement as risk sharing. But the producer/entrepreneur may not make any profit. In that case the financier gets only the capital back. There is no reward. Sometimes the producer/entrepreneur may sustain losses. In profit-sharing arrangements approved by Islam, these losses are borne by the financier.

 

In an interest-based economy such as capitalist societies have, a significant part of funds are provided to the producer/entrepreneur on condition of being repaid with a reward added irrespective of the results of the enterprise, whether it is profits or losses. The risks involved in productive enterprise are borne entirely by the producer. The financier does not share the risks of the productive enterprise, even though he gets the rewards for financing from out of the profits of enterprise.

There are many variants of risk sharing. Also there are different ways of transferring risks. Sometimes risks may be transferred to third parties—who neither provide funds for production nor organize production. These are speculators who “buy” risks. In the current state of affairs they have become the dominant factors in the world of finance.

This paper takes the position that buying risks involved in other people’s business is a speculative activity akin to gambling. The behavior of such risk takers is very different from the behavior of one taking risks involved in his/her own business. Their interest does not lie in mitigating risks. More often they wish enhanced risks as it expands their market opportunities and may bring them larger gains. Their interests lie in greater instability. The interests of those who buy risks to profit thereby are opposite the interests of the other parties---producers, fund owners and financial intermediaries. All three gain by stability but the buyer of risks gains by instability. Since society’s interest lies in reduced risks and increased stability the activities of speculators who buy risks to profit thereby should be regarded as anti-social.

 

A is the producer-entrepreneur being financed by B (using own funds or funds entrusted by others). B faces the risk that instead of getting any return on the funds advanced to A, he/she may suffer losses. Now comes X and offers to buy the risks from B.B would pay a price against which X offers to compensate any losses suffered by B in his/her arrangement with A. This is an example of risk shifting—transferring risk to a third party. I submit that this is not allowed in Islam. Even if X is doing similar arrangements with hundreds of financiers like B, the arrangement remains purely speculative. It is not based on any assessment of the productivity of the A’s ventures being financed. It is gambling. This arrangement that the likes of B are making with the likes of X to manage risk is very different from insurance. The Law of Large Numbers, the scientific basis for insurance, does not apply to business risks, as these are unique in each case.

 

The two ways of risk management, sharing or transferring, have different impacts on economy and society. Despite their predominance in the world today, risk management based on transferring the risk, or risk shifting, are less efficient as well as unjust and inequitable. A system of production and

Finance based on risk sharing will be more efficient and equitable.

 

The risk sharing arrangements are more efficient for two main reasons. First, allocation of investible funds is based on expected profitability (i.e., productivity) of the projects concerned, whereas in the interest based system allocation is heavily biased towards the creditworthiness of the project-sponsors, which depends on their wealth holding rather than on the expected profitability of the relevant projects. Second, a system of risk sharing encourages entrepreneurs and innovators—the dynamic people whose ideas take the economy forward. In contrast, a system that allows all risks to be transferred to entrepreneurs, guarantying the capital and a positive return to suppliers of investible funds protects and promotes the rentier class.

Financiers should not be allowed to transfer all the risks attending upon profit seeking on to the producer-entrepreneurs as this creates a pressure for accelerated growth that is deleterious for the environment.

 

Risk sharing results in a more equitable distribution of income and wealth. A system based on transferring all risk to entrepreneurs causes a continuous transfer of wealth from entrepreneurs to wealth owners (as the loss making enterprises are made to pay back the capital borrowed along with the interest promised from out of their past wealth), adversely affecting the distribution of income and wealth, reducing social cohesion and increasing conflicts.

 

RISK SHARING IN ISLAMIC FINANCE

 

Among the earlier forms of risk sharing between the financier and the business being financed, the prominent ones are partnership (musharakah) and profit sharing (mudarabah). Partnership may involve sharing the profits or losses, as the case may be or sharing the products, as in case of muzaraáh (share-cropping).

The earliest reported form of financial intermediation in Islamic societies was al-mudarib yudarib, a person obtaining finance on profit sharing basis entering into a similar arrangement with another person. It is possible to model Islamic banking in modern times according to this formula. The deposit money received by Islamic banks on the basis of mudaraba should be advanced on the same basis (of profit-sharing) to investors who would then finance productive enterprises directly or on the basis of murabaha, ijara, salam/istisna, etc .

That would have kept financial intermediation separate from productive enterprise. Financial intermediation would be based on sharing whereas productive enterprise could avail itself of a variety of arrangements; buying cash, buying on credit, taking advances with the promise of delivering later, taking on lease, etc. They would still face business risks requiring them to manage by diversifying, forward sales, hedging, etc. As businesses focused on certain kinds of enterprises they would be better equipped to manage business risks, unlike financial intermediaries who can not be expected to manage all kinds of business risks.

 However, in actual practice of Islamic banking and finance during the last three decades mark up (murabaha) leasing (ijara) and prepaid orders (salam and istisna) were adapted as devices for financial intermediation. The banks/financial institutions did not in reality have any use for the real goods/services, as they were not involved in production or exchange. They used the funds at their disposal to acquire real goods/services [using salam, for example]to be passed on to those who needed using these goods/services against a debt obligation on their part. The net result is cash for debt. This genre of intermediation seems ill suited to Islamic finance. The Islamic banks/financial institutions that relied on these sales based modes of financing in effect refused to share the risks of productive enterprises being financed. These risks were shifted to the enterprises themselves. These financing devices, like their counterparts in conventional finance, left a trail of debt obligations quantitatively larger than the cash initially advanced irrespective of the results of the enterprises so financed. This has the same impact on the macro economy as lending at interest. Even though sale with a mark up on purchase price, advance payments on counterparts to be delivered in future and leasing concluding into ownership are perfectly legitimate Islamic modes of doing business, when they are used for financial intermediation their macroeconomic impact is inequitable.

They favor financiers by shifting risks to the entrepreneurs. They create a constant pressure for growth (by mandating that total outputs be larger than total inputs) that is destructive of environment.

In doing so they violated the spirit of Islamic finance insofar as risk management is concerned. This has led to widespread dissatisfaction amongst the customers as well as dissentions amongst the sponsors of Islamic banking and finance. It has also opened to derision the advantages claimed over conventional banking and finance by Islamic banking and finance as most of these claims are based on sharing. This paper makes a plea to amend the ways and move from debt creating sale-based modes of finance to sharing based financial intermediation.

 

The above suggestion in effect amounts to a separation of commercial banking and investment banking in a special way. Investment making institutions would not be allowed to accept deposits from the public. They either seek funding on mudarabah basis through banks or sell shares collecting funds on the basis of shirkah. Deposit taking banks, on the other hand, will manage the payments mechanism only.

 

Risk sharing presumes a degree of trust that risk shifting does not require. The ease of risk shifting made it more widely practiced during the past three centuries that witnessed the rise of capitalism and decline of trust. It enabled greater and faster expansion in the financial economy bringing about faster and greater expansion in the real economy producing goods and services. But the practice of expansion through risk shifting has greatly increased the proliferation of interest bearing debts and speculation bringing in its wake greater inequalities in the distribution of income and wealth. Economic growth propelled by the pursuit of private gains has resulted in environmental deterioration, hegemonic nationalism and rising anxiety levels across all sections of society. The situation calls for a review of existing arrangements in the financial sector.

 

Islam’s prohibition of maysir (gambling) requires that unconcerned third parties should not be allowed to ‘buy’ risks. The essence of gambling is taking a risk one creates or invites. This applies to many speculative financial products like Collateralized Debt Obligations (CDO) or Credit Default Swaps (CDS). As noted above those who bet on certain market trends do not serve anybody’s interest. They make no contribution to risk management as such. As proved by recent crisis their intervention in the market makes the financiers reckless and less interested in closely monitoring the money trail. This resulted from the seemingly transferring of risks to those who bought them. When the crunch came it turned out that those who took over CDOs or CDSs were merely gambling on low incidence of defaults, they were not at all equipped to manage the risk of big defaults. Had the regulators prohibited risk shifting the lenders could have guarded against possible big defaults by following a more cautious and responsible lending policy.

 

Islamic Economics looks at production as a life sustaining activity. It aspires to promote a type of economy that sustains life for all, the weak and the poor included. It does not equate life sustaining productive activity with profit making activity. It is also aware of the limits to growth that ecological and environmental considerations impose on us. Even though Islam puts no cap on profits, it has not allowed manipulations that create profit opportunities for few by spreading false information among people. Market regulation with a view to preventing monopolistic practices, exploitation of the weak and outright fraud has always been a feature of Islamic economy. In current conditions it will have to include monitoring corporate governance for ensuring protection of the rights of all stakeholders in joint stock enterprises. Part of the task involves ensuring transparency and flow of information to all concerned. Welfare oriented market regulation should therefore be seen as a part of risk management mechanism in Islamic economy. Risk management should not be seen only from the viewpoint of investors, as the interests of labor, consumers and indeed those of the whole society are involved. Profits are not the only parameter for judging the efficiency of risk management. Rather it is social welfare that involves much more than business profits. Proper evaluation of Islamic risk management techniques requires new measures of value suiting Islam’s more inclusive paradigm. It should not follow the conventional criteria focused on money profits.

 

Future of Risk Management

 

Risk sharing has yet to receive the attention it deserves. It is hoped lessons will be learnt from the global economic crisis and efforts will be made to distance from risk shifting. This requires decreasing the role of debt finance and increasing the role of equity finance. An inverted pyramid of debt obligations is created by the practice of trading in debts, with a slender base of real assets at its bottom. There is no close monitoring of borrowers by lenders. Rather it is speculators shoving complex financial products into the portfolios of uninformed investors who rule the market. The rapid speed of financial innovations keeps the regulators a step behind the market manipulators to the disadvantage of the ordinary investor. The regulators themselves have to change their priorities from protecting business profits to ensuring stability, transparency and fairness. The market cannot be rid of gambling like speculation without restricting trading in debts and curbing risk shifting. Corporations as well as individuals cannot be absolved of the responsibility of keeping the planet earth habitable as well as maintaining social cohesion by ensuring equity.

Islamic financial institutions need to make renewed efforts to expand the practice of equity finance and of risk sharing. The reasons often cited why such efforts did not succeed in the early days of Islamic banking experience. i.e., in 1970s, may no longer apply. There is more information available at lower cost facilitating participatory finance as compared to debt finance. Also, the recent disillusionment from the “Greed is Good” philosophy of economics is likely to help a socially responsible and ethically informed approach to business and finance. The regulators are also wiser after the successive financial crises capitalism has witnessed during the last three decades.

As pointed out above, one of the advantages of equity finance as compared to debt finance is that whereas the later leaves a trail of fixed payment obligations the former creates obligations in sync with the performance of the investments financed. Public monitoring of the performance of joint stock enterprises can go a long way in enlarging the scope for equity finance. A more democratic structure of monetary management at the national and global level is necessary for ensuring that money is not managed in the interest of profiteers but in the interest of humanity at large. This will require replacement of the current monetary authorities at the national and international level that are largely representative of the profit seeking wealth owners by representatives of people who act as guardians of social interest.

 

To summarize, risk management in Islamic framework should ensure that:

 

·         Debt proliferation is minimized. This implies that corporations raise additional funds via equity, not by issuing bonds.

·         Interest on debt is not practiced. This will in effect kill the bond market.

·         Debt is not traded.

·         Risks are shared between financiers and producers/businessmen

·         Regulators should not allow purchase of business or financial risks by outsiders not involved in the business or supply of investible funds for the business but only taking chances on the outcome.

 

APPENDIX

[Reproduced from the author’s essay: Comparative Advantages of Islamic Finance, presented at the Harvard Islamic Finance Forum in 2002, included in the Forum’s relevant publication and available at the author’s website http://www.siddiqi.com/mns]

Since financial intermediation does not involve selling goods and services directly, it would be more appropriate to get financial intermediaries involved in Murabaha business indirectly, as I will explain later. The same applies to other forms of business like Salam (payment now for delivery of agricultural goods in future), Istisna’( prepaid orders for manufactures), leasing, etc. A financial institution is not fully equipped to handle these businesses directly. It is often reluctant fully to expose its capital to the risks involved in direct businesses. As a result it tries to make the transactions as risk free as possible. It does not care if this means, on the average and in the long run, settling down for a lower rate of return.

 

Now imagine a whole range of businesses doing Murabaha, Salam, Istisna and leasing. These businesses would know the risks they are taking. They would also be able to diversify their activities as a means of reducing risk. Perhaps they are already specialising in handling different market segments in terms of the commodities involved. These  businesses would need financing. This financing could come from Islamic financial institutions. This way there would be a buffer between the changing circumstances of real businesses and those handling only finance. It will thus relieve the Islamic financial institutions from the need to reduce risk by making their contracts look like payment of less money now in exchange of more money to be received in future. The fact that their stake will be not in individual deals based on one of the contracts mentioned above but in a large basket of deals will make a crucial difference. In its own interest, the business being financed will have reduced the risk of loss by diversification and other methods. The financial institution will have the added opportunity of diversification by offering its funds to a variety of businesses.

 

What would be the basis for the Islamic financial institutions’ financing of Murabaha companies, Leasing companies, etc.? In my opinion the most appropriate form will be Mudaraba or profit sharing. Islamic banks accepting people’s savings in their investment accounts on the basis of Mudaraba would be giving that money out on  the basis of Mudaraba. This conforms to the earliest form of financial intermediation discussed in Islamic jurisprudence, al mudarib yudarib ( One taking other person’s money on the basis of Mudaraba giving that money to yet another person on Mudaraba ). The risks involved will be financial risks which financial intermediaries have learnt, and continue learning, how to handle. Business risks will become the concerns of business houses closer to those who buy and sell, even produce and import/export, or build and lease, hire and sublet, etc. There will be no need to twist and turn a trade deal to make it serve the purposes of a financial intermediary.

 

One might need to encourage establishing a whole range of companies: Murabaha companies, Salam/Istisna companies , Leasing companies, etc. so that finance is channeled from Islamic banks to those actually engaged in production of wealth. Whether it is the building and construction sector or agriculture, manufacturing industries or the transport and communication sector, foreign trade or domestic commerce or the government’s infrastructure building activities, ways can be found to meet their financial needs through these companies, without recourse to interest based lending and borrowing.

This vision, which involves separating purely financial transactions from business transactions, has two advantages in comparison to what we actually observe today in the Islamic financial markets. Firstly, it would comprise a mixture of sharing based modes with trade based modes of financing that result in creating fixed payment obligations or debts , unlike the current situation dominated by trade based modes. Secondly, it will enable Islamic financial institutions to do needed long term financing, a field from which they are presently shying away. With the exception of istisna which can be a basis of long term financing, all other trade based modes of financing ,e.g. Murabaha, leasing and salam, are suitable only for short term financing. Given this change they could rightfully demonstrate how their activities avoid contributing to the instability of the system, something we accuse interest based institutions of doing. By doing this the system will enjoy the unique feature of sharing based intermediation: synchronization between revenues and payment obligations, and still retain the flexibility which the presence of very low risk modes of financing impart to a system. A strong presence of sharing based modes of financing will give credibility to the claim of Islamic financial system’s being more just than the conventional system.



§ Valuable comments on a previous draft by Professors Abbas Mirakhor, Asad zaman, M.Fahim Khan and Shamim A.Siddiqi are gratefully acknowledged. What you find before you is, however, entirely my responsibility.