Tuesday, November 24, 2009

How Islamic Banks Can Reduce Risk Exposure (Guest Post)

This is a guest post from Siddhartha Herdegen. Siddhartha Herdegen is an economist and consultant studying Islamic finance in Bahrain. He received a master's degree in Global Leadership from the University of San Diego in 2008.

As a classically trained economist familiar with conventional finance I was intrigued by the promise of Islamic finance. It was a different form of financing based on community oriented Shariah law. It avoided the pitfalls of interest based debt financing and easy credit which have plagued the west in recent years and it purported to share risk rather than transfer it.

I have been disappointed however in the realization of that promise as more often than not Shariah compliant Islamic banks and financial institutions focus on recreating the mistakes of conventional institutions rather than developing a true asset-based, shared risk alternative.

Intention of Shariah

The unifying concept behind Shariah is the benefit of society and every law is designed with the community’s welfare in mind. Shariah recognizes that in order to advance economically societies must take risks. Therefore Islamic banks should strive to understand the socially beneficial types of risk.

Islamic banks do not profit from money lent on credit because the interest earned would be riba which is impermissible under Shariah. Even though there are risks associated with lending on credit—most prominently default risk—these risks are not risks which are socially beneficial.

Shariah considers these profits a drain on future productivity and forbids interest lending. Other risks however are beneficial to society such as entrepreneurial risk. When an entrepreneur creates a new product or service, or purchases inventory for resale, they are taking a risk that society may not value their product or service.

This is the risk entrepreneurs throughout history have taken; some have been successful, others have failed. Those that succeeded have benefited society through improved technology and efficiency. The profits earned by such successful entrepreneurs are permissible under Shariah because they are derived from benefiting society.

Principle of Shared Risk

One of the bedrock principles of Islamic finance is this idea of shared risk. The Shariah approved products for business partnerships and so called Islamic bonds reflect this risk sharing aspect.

Mudarabah profit and loss sharing (PLS) arrangements for example, allow the Mudarib to profit from business gains but also stipulates he should lose money in the event of a business loss. A Musharakah contract likewise, shares business losses between participating parties.

Of the Shariah approved business arrangements, Sukuk is probably the most secure investment as it is generally backed by real property which is then leased back to the originator. Still, in a Sukuk the participants should recognize they are involved in a business venture and loss is a possibility. If the possibility of loss is not there, the intention of Shariah is distorted.

Risk in Islamic Banking Operations

As previously stated, risk justifies economic gain under Shariah but not all risk. Risk which is not socially beneficial such as gambling is not allowed as the transaction serves no socially useful purpose. Risk of inflation or the time value of money is compensated for by paying less for forward sales such as Salam or Istisna and more for financed sales in Murabaha.

Profits from guaranteed interest however are risk free and are therefore considered a drain on society’s resources. These profits are risk free because a loss occurs only when individuals act in an unethical way. When profits are guaranteed they become risk free and such profits are contrary to Shariah.

In business ventures there are no guarantees of return because the business may not be profitable even when everyone is acting ethically. Consumers will only purchase the offered product or service if they perceive it as being beneficial to themselves. There is nothing immoral about using resources in the most efficient manner.

The path toward technological improvement and economic efficiency is full of experimentation and mistakes. It is inevitable many businesses will fail while attempting to create better products and services. While money is a means of easing transactions it is also a means of storing labor. Excess productivity can be stored in the form of money until it is needed. In an economy without banks this excess wealth or stored labor could be put to use by personally investing in a business venture.

The difficulty of bringing together individuals with excess wealth and those with promising business ideas is a drag on the economy as it is haltingly inefficient. One of the roles of banks then is to bring together those with capital and those with ideas, to facilitate the transaction by providing expert analysis and to spread the risk of failure over a pool of investors.

Shariah recognizes the benefits of this arrangement and allows for the operation of banks with the stipulation they operate as socially beneficial institutions rather than simply a conduit for wealthy people to increase their wealth through obtaining risk free rents.

Using Conventional Banking Model Increases Risk

The development of conventional banks in western economies led to a system of finance which was incompatible with Islamic thinking. As Islamic institutions have gained a foothold in the financial marketplace they have done so primarily by mimicking the success of conventional financial institutions and copying their products.

Murabaha sales for example are very similar to conventional loans with the profit rate being equivalent to interest charged by conventional banks. Likewise, Musharakah mutanaqisah for real estate has an appearance similar to conventional loans on property.

In areas where real assets and durable goods are being purchased it is appropriate that Islamic institutions give consumers the ability to purchase expensive goods over time. In other areas though such mimicry leads to products which are contrary to the intention of Shariah.

Let’s look again at the principle of shared risk. Ostensibly, Islamic banks which are set up as Mudarabah companies do this by paying depositors a portion of their profit as compensation for the risk of operating a business.

Traditionally such contracts stipulate the Mudarib (in this case the depositor) is eligible to receive a portion of the profit but also must bear the risk of losing money if the venture is unprofitable. This risk of loss in failure justifies the profit earned on success.

Such an arrangement makes bank depositors who are used to receiving risk free rent nervous, and Islamic banks have catered to this concern by guaranteeing returns. Still others have gone as far as guaranteeing a certain minimum rate of return. These stipulations place the burden of failure on the bank rather than the investor and reveal the Mudarabah to be a fa├žade.

Islamic banking is still in its infancy and this creates some hardships in terms of liquidity. Immature financial markets make it difficult for banks and other financial institutions to operate in a purely Shariah compliant way. Banks often rely heavily on Sukuk offerings to guarantee stable return rates.

These Sukuk however can increase banks’ risks if they have not been structured properly. Some institutions issuing Sukuk do not supply sufficient asset backing or do not fully transfer the asset to the special purpose vehicle (SPV) set up to facilitate the Sukuk offering. In such cases banks leave themselves exposed to increased risk if the Sukuk issuer runs into financial difficulty. These Sukuk offerings are Shariah compliant in name only.

As we have seen lately conventional banks compound their risk by leveraging their funds through fractional reserve banking; essentially borrowing money on credit and lending or investing it. By not lending borrowed money Islamic financial institutions should be more insulated from this compounding of risk.

Unfortunately, following the uninspired banking practices of conventional banks, Islamic banks often use Tawarruq or “commodity Murabaha” to provide liquid funds for bank operations; by doing so they make themselves susceptible to compound failures.

In an ideal world, Islamic financial institutions would make more effort to comply with the intention of Shariah than to conform to conventional banking standards. Banks established as a PLS entity should actually share the risk of the business with their depositors by allowing them to incur losses as well as reap rewards.

The Dilemma of Asymmetric Information

One of the problems in banking is the fact that depositors are at the mercy of the bank executives when it comes to information about the institution. They must rely on proper reporting and ethical business practices for their income.

One reason depositors are reluctant to take on the risk of bank losses is they are afraid in bad years the bank would pass on their losses but in good years banks would hide gains through unethical accounting tactics. This asymmetry of information creates an economic barrier banks must work hard to overcome in order to have truly Shariah compliant business structures.

Because bank executives are often not at as much risk as depositors under a truly Shariah compliant scheme there is a potential for moral hazard in that poor business practices, while they affect the institution, do not typically affect the executives directly. Therefore they have little incentive to be diligent in their research or prudent in their investments.


To reduce the risk Islamic financial institutions are exposed to they need only fully adopt Shariah standards. In order for them to accomplish this however, they must cede some control by making their books more transparent and acting in more ethical ways. When depositors know bank executives are making decisions with their own wealth at stake they will feel more comfortable with the outcome, whether good or bad.

It is perhaps not insignificant that such changes would bring Islamic banks closer to the ideal of community based, asset-backed, full-reserve banks envisioned by Islamic financial theory. In so doing they would be offering Muslims a real alternative to conventional banking and creating a model of banking which would be significantly more resistant to speculative forces. Banks built on Shariah ideals would also be more resistant to economic downturns and inflationary pressures.

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