Tuesday, October 25, 2011

Can Islamic finance return to the basics?

There was a very good opinion piece by Dhafer Alqatani that looked at the potential for standardization of the Islamic finance industry.  The key paragraph in the article was:
Shari’ah-compliant products and services have to be repositioned, where those products and services should be revisited, reviewed and consolidated as well as documented, thus establishing stronger foundations by going back to the basics which will pave the way to standardization and eventually the globalization of uniform structures and formats that are Shari’ah-compliant and acceptable to the critical mass, both Muslims and non-Muslims, without compromising the industry’s authenticity and integrity. 
The important point is that Islamic financial institutions should go "back to the basics".  Last week, I spoke at the Financial Management Association's Annual Meeting in Denver and one of my fellow panelists (from the World Bank) addressed the question of whether Islamic finance is more resilient and lower risk than conventional finance.  His conclusion was that it is not a foregone conclusion that the Islamic finance industry was lower risk because when you look at the structure of sukuk, for example (he showed the Nakheel sukuk), they are incredibly complicated financial instruments and that complexity is itself a risk (just as the complexity of the mortgage-based products that triggered the crisis posed a risk). 

The underlying reason I think that this complexity has arisen is because the Islamic finance industry has focused on creating financial products in a way that they are Shari'ah-compliant, rather than starting from 'first principles' of finance (i.e. what need are they addressing) and looking at how Islamic finance can meet these needs.  To some degree it was unavoidable that financial engineering to create "Islamized" versions of conventional financial products became the standard practice for Islamic finance because the institutions doing it operate in conventionally-dominated financial markets with regulations designed around the conventional finance industry.

However, it does not necessarily have to always be this way.  Where my views differ, however, is that I think a top-down approach will take too long and involve too many conflicted parties to be workable.  I think the better approach is more bottom-up.  It is much easier for one financial institution to change the way it thinks about offering Islamic financial services than to change the entire industry in one fell swoop.  After some controversy around the bai bithamin ajil (BBA) in Malaysia, there was a divide with some banks deciding to curtail their BBA activities, while others said they would continue to use BBA.  The difficulty in the bottom-up approach is about how it gets started, and I don't have a solution to that problem. Ultimately, it will be driven by market demands for alternatives to the products being offered today.

See the index of Islamic Finance Complexity posts: http://investhalal.blogspot.com/2011/11/islamic-finance-complexity.html


Anonymous said...

Islamic finance is a cynical farce. The complexity arises from restructuring standard derivatives based on cash flows due to interest into exotic derivatives which pay out some kind of capital appreciation which is deemed not to be interest by well renumerated scholars.

Blake Goud said...

I don't disagree that there is some cynicism involved in some of the more complex products. However, the vast majority of Islamic finance is designed to create plain vanilla financial products.

The deficiency I see in the development of Islamic finance is a focus on doing something different than conventional finance. That is why I am exploring the financial needs of people who use Islamic finance (or really any finance) to try and sift through the cynical products and those that provide something that is useful to consumers.

Naji Mtaa-lah said...
This comment has been removed by the author.
Naji Mtaa-lah said...

Dear Blake,

I think indeed that the Islamic Finance Industry is deriving from its original purpose by creating product as complex as its couterpart in Conventional Finance.

The rebirth of Islamic Finance will happen when, as you said, it will take care of "what is the need that I have to satisfy in a simpliest way".

I guess that the bottom-up approach will be successful when customers will be aware of what they are "buying".

Nice Job !