Sunday, April 11, 2010

What does Islamic finance provide and how can it be improved?

With some of the criticism of Islamic finance as nothing more than a replication of conventional finance, I took a chance to think over what the goals of Islamic finance should be and where the current state of the industry fits within the larger idea.

First, the criticism of Islamic finance as a replication of conventional finance does have merits. The way Islamic finance works today is not one that is seeking to completely overhaul the conventional financial industry. Instead, it seeks to provide the basic financial products like bonds and banking services to Muslim consumers who don't want to work within an interest-based financial system. For the most part, these consumers want to have the same opportunities as those who are comfortable working with the interest-based financial system.

The basic products are replications of conventional financial products and in most cases, that is not a bad thing. Using modified contracts to achieve the same ends as conventional finance will make it more likely that the products are comparably priced with conventional financial services, which is important. That these products are priced accordingly with conventional financial products is a benefit not a cost. There should be a goal within the industry to make the plain-vanilla products equally priced so there is no premium paid for using Islamic versus conventional financial products. The important thing is that the means and the intent by which these products are delivered is that they should be put together in a way that is broadly accepted by scholars as Shari'ah-compliant.

There are limits to how far this replication can proceed. There are financial innovations that are detrimental to society at large and if these are replicated in Shari'ah-compliant forms, then there is clearly a problem. The main deficiency with the Shari'ah review process as I understand it is that there is a focus on the specific contractual form, not necessarily as thorough a review of the social implications of a given product. If a product is created (e.g. in the conventional space, the negative amortization mortgage) which relies upon a continually rising house price to benefit the consumer and in any other case will harm him on average, then it would not be appropriate to create a Shari'ah-compliant version of the product.

It is not certain that the use of murabaha or tawarruq financing necessarily produces this social harm because in its absence, there will be a voluntary decision by many consumers to not receive financing at all. This will avoid some of those consumers from entering into a situation where they endanger their financial health, but it will also create hardship for some consumers who could benefit from receiving credit to finance education, healthcare, or a new business. On balance, there is not enough evidence that the use of murabaha or tawarruq creates net social harm.

Similarly, the use of asset-based sukuk which replicate an unsecured bond may not create anything different from a conventional product, but it provides an investment opportunity, for example, for an investment portfolio managed in a Shari'ah-compliant way for a pension fund or takaful provider that can introduce diversification in the way that a profit-and-loss sharing equity investment cannot. The product will not necessarily create a new type of financial system, but it will provide benefits to the investors who are not able to diversify using a conventional bond allocation. In its absence, there will be overallocation to real estate or equities, which are much more volatile and can lead to significant harm if (read: when) there is another significant market downturn.

That is the 'good' type of replication that I see. There is also some that is negative. The creation of products (particularly some of the structured products) that come with high fees for investors and these fees may leave them worse off than if the products had never existed in the first place (although providing significant income to the financial institutions and law firms which created them). As the real estate boom in some areas of the Gulf turned into a bubble which eventually burst, there were plenty of Islamic financial products which fall into the category of what I described. This distinction should be made clear between the over-structured products that are accompanied high fees from the basic banking products which promote inclusion within the financial systems for Muslim consumers that choose to avoid the interest-based conventional financial system.

However, that perspective alone feels a bit empty in terms of what the Islamic financial system is supposed to provide and the similarities it shares with socially responsible and ethical finance. There is one aspect that is omitted from the above discussion that is key for the Islamic finance industry to live up to its billing as another form of ethical finance. There should be a proactive and positive approach to financing ethical businesses and doing good for the world through its operations. Right now, it is too focused on avoiding that which is prohibited while ignoring doing what is encouraged. There are two areas where I think a start should be made: 1) make an extra effort to finance businesses that are environmentally responsible and those that are focused on making businesses more environmentally friendly (companies that provide products that make more efficient use of energy and those that can help develop and integrate renewable energy); 2) use some of the profits and expertise from creating Islamic financial products to help those who are less well off, through focusing on providing financing to small and micro-businesses.

These two areas are important for Islamic financial institutions because they promote beneficial activities for the world and people in need while not forcing the industry from leaving its core area of expertise, which is in financing businesses and individuals. There are many charitable organizations that can provide other services where they have better skills at how to do this efficiently. In the financial area, Islamic financial institutions can work more closely to use their role as a financial intermediary to improve the state of the world. If they choose not to do this, then it would be fair to accuse them of being little more than a re-structured version of conventional banks without a special feeling of obligation to pursue a more ethically focused form of business.


Siddhartha Herdegen said...

A nice piece on a question I wrestle with constantly.

I also wonder how much Islamic finance should assert its differences. I would like to see Islamic banks maintaining ownership of the assets their customers purchase by using more musharakah mutanaqisah and ijarah contracts instead of marabaha. This would prevent borrowers from subsequently selling off the purchased assets to create an unsecured loan.

The standard argument against this is if Islamic finance becomes too restrictive people will just use conventional finance, but I don’t think it’s necessarily a bad thing to differentiate yourself. If people want unsecured money let them use conventional sources. It will only make Islamic financial institutions stronger.

Blake Goud said...


I understand your point and I think there is something to differentiation. However, there is a simple fact that many Muslims will not use conventional banks under any circumstances, but whose needs do not fit with a musharaka mutanaqisah or ijara. For example, how would one obtain a student loan with either of those contracts? There are ways, but it is extremely complicated and although I know the musharaka idea is being considered, it is not something that will receive the attention due to the issue of education by Islamic banks using that structure.

The key concern that I see for being a fully differentiated bank without the use of some contracts which mimic conventional products is that it misses a valuable opportunity to promote inclusiveness within the financial system. Those without access to the financial system miss the prospect of being harmed by it, but also miss the opportunity to benefit from it (e.g. by obtaining financing for their education).

What are your thoughts on how a 'differentiated' Islamic banking system can still promote the inclusiveness among people who may not fully understand the risks of an ijara or musharaka contract versus a murabaha (which is similar to the conventional financial products they understand and want to avoid)?

Siddhartha Herdegen said...

Well, you bring up a good point about student loans. But there are many instances in which people would like to borrow unsecured funds. I think the question is, should Islamic financial institutions facilitate such borrowing?

Many Islamic scholars have argued against the corrosive social effects of consumer debt and pointed to conventional finance as guilty of promoting such borrowing. I don’t know the Shari’ah position on this but maybe avoiding loans for consumptive purchases was an intentional effect.

By encouraging differentiation I was saying I wanted Islamic finance to be more faithful to the intent of Shari’ah contracts. As we’ve seen in the sukuk market there’s a lot of winking going on concerning the transfer of assets the SPVs.

There are similar shady maneuvers when it comes to binding promises, etc. In my opinion, if Islamic financial institutions took a hard line on these machinations it would not only make them stronger institutions but would give people a true alternative to conventional finance.