Lecture Three: Problems and Prospects of Islamic Banking and Finance
(Delivered
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 mother’s 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.
This
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.