Risk Sharing and Islamic Finance Abbas Mirakhor, and Noureddine Krichene, New Horizon
Equity-Based Islamic Finance and Risk Sharing
The foundational principle of Islamic finance is the prohibition of interest (riba) and interest-based contracts. This prohibition has been stated in many verses in Quran and was explicated in many sayings of the Prophet PBUH.
In Quran, Chapter Two, verse 275, Allah says: 'those who devour riba (interest) will stand except as stands one who the evil one by his touch has driven to madness. That is because they say exchange is like riba; but Allah has permitted exchange and forbidden riba.' In Chapter Two, verse 276, 'Allah will des troy riba; but will increase charity'. In verses 278-279, Chapter Two, 'Oh you who believe fear Allah and give up what remains of riba; if you do it not, take notice of war from Allah and His Apostle'.
As can be observed from the last part of the quoted verses, there is no rule violation in the Quran that has been treated as seriously as the charging of interest which is considered a paramount act of injustice. An economic understanding of the essence of the above verses – that interest-based debt contracts have to be replaced by contracts of exchange – would require analysis of particularities of the two contracts. Interest rate-based debt contracts have two major characteristics. Firstly, they are instruments of risk shifting, risk shedding and risk transfer. The second characteristic of interest-based debt contracts is that upon entering into this contract, the creditor attains a property rights claim on the debtor, equivalent to the principal plus interest and whatever collateral may be involved, without losing the property rights claim to the money lent. This is a violation of Islamic property rights principles. The most important of these principles are that:
The Creator has ultimate property rights on all things.
He (swt) has created resources for all mankind and no one can be denied access to these resources.
Work is the only means by which individuals gain the right of possession of property when they combine their physical/mental abilities with natural resources to produce a product.
Since resources belong to all mankind, a right is created in the products produced by the more able for the less able; in effect the less able are silent partners in the products, income and wealth produced by the more able whose share has to be redeemed.
All instantaneous property rights claims, such as theft, bribery, interest and gambling, are prohibited.
A person can transfer a property rights claim to another via exchange, inheritance or the redemption of the rights of the less able. Interest rate-based debt contracts create an instantaneous property rights claim for the creditor against the debtor regardless of the outcome of the objective for which the two sides entered the contract. The creditor obtains this property rights claim without commensurate work. Ordaining exchange to replace interest rate-based debt contracts has significant economic implications. First, before parties can enter into a contract of exchange they must have property rights over the subject of exchange. Second, the parties need a place to undertake the exchange: a market. Third, the market needs rules for its efficient operations. Fourth, the rules of market need enforcement. Exchange facilitates specialisation and allows the parties to share production, transportation, marketing, sales and price risks. Therefore exchange is above all a means of risk sharing. From an economic standpoint, by prohibiting interest rate-based contracts and ordaining exchange contracts, the Quran encourages risk sharing and prohibits risk transfer, risk shedding and risk shifting. In a typical risk sharing arrangement such as equity finance, the parties share the risk as well as the reward of a contract. In an interest rate-based debt contract the risk is transferred from the financier to the borrower, with the financier retaining not only the property rights claim to the principle and interest but also that of any collateral that has enhanced the financing arrangement. In a risk sharing arrangement such as equity participation, the asset is invested in remunerative trade and production activities, the return to the asset is not known at the instant the asset is invested and is therefore a random variable, making equities risky assets. In equity investment, owners of money and physical assets, and entrepreneurs, share the risk; their income is random and depends on the performance of the equity investment.
Not all debt contracts are forbidden in Islam. However, they have to be free of interest. Because they are not remunerative, debt contracts cannot play a significant economic role in financing trade and investment in Islamic finance. How about borrowing by the needy and the poor for survival? Before Islam, and also in medieval Europe, the poor used to borrow by pledging their property as a collateral. As default was a common event, the poor risked the loss of all their properties with the consequence that often they were forced into slavery. As a direct consequence of the principles of property rights, in Islam, the poor, the orphans and the needy have a prescribed and mandatory share in the earnings of assets, which provide a safety net. Thus, the rich are mandated to share the risk of the life of the poor. Prohibition of interest and the obligation of zakat and other prescribed duties levied on the well-to-do are stated often jointly and not separately in both the Quran and the Sunnah. When the economically more able shirk their duty of redeeming the rights of the less able, the poor will have to borrow or fall in abject poverty. Existence of wide-spread poverty in a society is prima facie evidence of shirking of the duty of sharing.
Islamic Finance is Inherently Stable, Conventional Finance is Inherently Unstable
Islamic finance, by emphasising equity investment and risk sharing, has characteristics that render it inherently stable. Conventional finance, being debt- and interest-based, has proven to be unstable. Hyman Philip Minsky, a prominent American economist, dubbed conventional finance instability 'endogenous instability' because conventional finance experiences a three-phased cycle: relative calm, speculation and fictitious expansion, and then crisis and bankruptcy. The bankruptcy aspect of conventional finance is not limited to the private sector as the recent Greek debt crisis illustrates; governments too can face bankruptcy. Recent historical analysis has demonstrated that all financial, banking and currency crises have been ultimately debt crises. The widespread bankruptcies of many developing countries in the recent past shows that often governments that borrowed what were considered as reasonable debt levels compared to their GDP found themselves in an unsustainable debt spiral due to increased debt service obligations. Many found themselves with debt levels many times larger than the original borrowed.
In the aftermath of the financial crisis that broke out in August 2007, the International Monetary Fund (IMF) and regulators in industrial countries have called for capital surcharges on banks and for strengthened regulation and supervision to make conventional banking less crisis-prone. In contrast to the regulatory reforms proposed by the G20 group in its November 2008 summit and in following summits, the Chicago Reform Plan (1935) advocated a financial system based on 100 per cent reserve banking, equity-based banking, and elimination of interest rate-based contracts. In line with many classic economists, the authors of the Chicago Reform Plan (1935) considered that modern banking created fictitious credit, expanded in a multiplicative way through money creation, and contracted in a multiplicative way through money destruction, causing grave gyrations in asset prices and large fluctuations in real economic activity. In the Chicago Reform Plan (1935), deposits at investment banks would be considered as equity shares and would finance long-term investment. Maurice Allais, a Nobel laureate in economics, strongly advocated the Chicago Reform Plan (1935) and called for a reform of the stock market in order to enhance its role in financial intermediation and reduce its speculative aspects.
Islamic Finance and the Evolutionary Process of Equity Financing
In an Islamic finance system in which there are no risk-free assets, where all financial assets are contingent claims, and in which there are no interest rate-based debt contracts, it has been shown that the rate of return to financial assets was determined by the return to the real sector. Output is divided between labour and capital. Once labour is paid, the profit is then divided between entrepreneurs and equity owners. Since profits are ex post, returns on equities cannot be known ex ante. It is demonstrated that in such a system there is a one-to-one mapping between finance and real economy and that an equity-based finance is stable as assets and liabilities adjust to shocks, therefore the system is immune to banking crisis and disruption in the payments mechanism.
Equity financing has been an essential mode of financing of trade and industry throughout the centuries. It continues to be employed as a mode of financing in many developing countries where it has evolved with the advent of enterprise creation and economic growth.
Historically, enterprises were established with share ownership and were recorded as share owned or anonymous enterprises. Shares were not necessarily offered to the public via stock markets and were primarily private contributions of founders of the company. In many countries, share-owned companies continue to be formed without necessarily resorting to stock market public offerings. Nonetheless, with the spread of equity-financed firms, stock markets, as a form of organised exchanges, became an integral part of financial intermediation and in channelling savings to long-term investment. Stock markets, considered as the first-best instruments of risk sharing, offer liquidity for listed shares in that the owners of listed shares may s ell them when they need liquidity. Moreover, liquidity and attractiveness of stocks have been enhanced by the proliferation of derivatives such as options and futures that allow portfolio insurance that provides protection against bear markets. For instance, a protective put provides protection against stock downturns. While stock markets have been vulnerable to speculative bubbles and stock market crashes have been ruinous to savers and to pension funds, the main reason has often been informational problems, self-dealings such as insider trading, unregulated short sales that promote unnecessary speculation, lack of protection of minority shareholder rights, weak regulation and supervision, and even weaker enforcement of contracts. The development of Islamic finance and its equity financing aspects could be significantly rewarding for countries that seek an alternative to the conventional system. Many developing countries have tried to develop conventional banking to enhance their financial infrastructure; however, a large number of these countries have experienced repeated severe banking and currency crises and have failed so far to create a deep and stable financial system. Economic growth and employment in these countries continue to be severely constrained. Developing long-term equity-based banking and efficient stock markets could be a promising alternative for financing growth and employment creation in all countries.
Islamic Finance: Balance Between Short-Term Less Risky Liquid Assets and Long-Term, Higher Risk and Less Liquid Assets – The Vibrant Stock Market Approach
For Islamic finance to achieve its expected potential, it has to emphasise long-term investment and economic growth and not confine itself to short-term, highly liquid, and safe commodity trade and cost-plus sale financing contracts. Long-term investments are more risky than short-term investments. In fact, the more distant in time the payoffs of an investment are, the riskier these payoffs become. Risk increases with time. However, long-term investments have higher expected payoff. Nonetheless, a stumbling block to long-term finance is liquidity, informational problems, lack of level playing field between equity and debt financing, weak regulation and enforcement as well as non-protection of minority shareholder rights. The liquidity problem has been addressed by developing secondary markets where securities can be sold. The liquidity of equity shares is enhanced through two channels. Firstly, over-the-counter (OTC) trade where deposits in investment accounts held at an Islamic bank are transferred to a new owner who redeems the previous owner for the amount being deposited in long-term equity accounts. The second channel is organised stock market exchanges where listed shares can be traded at low cost in liquid markets.
Risk sharing and equity finance was emphasised in a recent paper, presented at the Inaugural Securities Commission Malaysia (SC) and Oxford Centre for Islamic Studies (OCIS) Roundtable, entitled 'Developing a Scientific Methodology on Shariah Governance for Positioning Islamic Finance Globally'. The paper notes that the first best instrument of risk sharing is a vibrant stock market, which is the most sophisticated market-based risk sharing mechanism. Developing an efficient stock market can effectively complement and supplement the existing and future array of other Islamic finance instruments. It would provide the means for business and industry to raise capital. Such an active market would reduce the dominance of banks and debt financing where risks become concentrated and create system fragility. In the current evolution of Islamic finance, what needs emphasis is long-term investment contracts that allow the growth of employment and income and expansion of the economy. Moreover, through holding diversified stock portfolios, investors can eliminate idiosyncratic risks specific to individual investor as well as to firms. Diversification can allow reduction in the overall portfolio risk. The paper calls for strengthening the regulatory framework, levelling the playing field between debt and equity, reducing the costs of equity market operations through provisions of laws and regulations that promote market based barriers to speculative abuse of stock markets, protection of minority shareholders, regulation of reputational intermediaries – such as accountants, lawyers, and Shariah scholars – that certify companies and financial instruments, and strong enforcement of contracts. The first best instrument of risk sharing is a vibrant stock market, which is the most sophisticated market-based risk sharing mechanism. Developing an efficient stock market can effectively complement and supplement the existing and future array of other Islamic finance instruments.
Islamic finance, based on risk sharing, has had a long and distinguished history, particularly in the Middle Ages when it was the dominant form of financing investment and trade in the global economy. Even today, venture capital financiers use techniques very similar to Islamic risk sharing contracts such as mudarabah. Conventional banking, which began with the goldsmith's idea of fractional reserve banking, received strong support from heavily subsidised last resort lender central banks and rules and regulations heavily biased in favour of interest rate-based debt contracts and against risk sharing contracts. These developments have helped the perpetuation of a system that a number of well-known scholars, such as Keynes, deemed detrimental to growth, development and to equitable income and wealth distribution. In more recent times, reforms proposed in the Chicago Reform Plan (1935) and in a growing literature thereafter have argued that the stability of a financial system can only be assured by 100% reserve banking to support the payment system of the country – which obviates the need for costly central bank guarantees, on the one hand, and promotes equity-based investment banking, on the other. Islamic finance, based on risk sharing in investment activities and 100% reserve banking to ensure the safety of the payment system, has been shown to be inherently stable and socially equitable. In such a system, there is a one-to-one mapping between the growth of the financial sector and real sector activities. This means that credit cannot expand or contract, as it does in the conventional system, independently of the real sector. To foster further the development of Islamic finance, there is a need to emphasise risk-sharing aspect of the system; remove biases against equity finance; reduce transaction costs of stock market participation; create a market-based incentive structure to minimise speculative behaviour; and develop long-term financing instruments as well as low cost efficient secondary markets for trading equity shares. These secondary markets would enable a better distribution of risk and achieve reduced risk with expected payoffs in line with the overall stock market portfolio. Absent true risk sharing, Islamic finance may provide a false impression of being all about developing debt-like, short-term, low risk and highly liquid financing without manifesting the most important dimension of Islamic finance: its ability to facilitate high growth of employment and income with relatively low risk to individual investors and market participants.
Abbas Mirakhor is the first chair in Islamic finance at the International Centre for Education in Islamic Finance, Malaysia. Noureddine Krichene is an economist at the International Monetary Fund (IMF), with a PhD from University of California, Los Angeles.
This article was first published in NewHorizon, the magazine of the Institute of Islamic Banking and Insurance (IIBI). For further details, please visit the IIBI's website www.islamic-banking.com