Impetus to Islamic finance

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One of the most serious gaps in Islamic finance is the reluctance of market players to promote risk-sharing financial products, say the authors of Globalization & Islamic Finance: Convergence, prospects, & challenges (, Hossein Askari, Zamir Iqbal, and Abbas Mirakhor. They reason that institutions to support risk-sharing, partnership-based, and equity-style financing and investment are the most critical to achieving the full potential of an Islamic financial system.

“By design, Islamic financial institutions and markets should encourage partnerships and equity-sharing securities, but in practice, the proportion of such assets on the balance sheets of Islamic banks is minimal… Islamic financial institutions' first preference is for financing instruments that are generated through sale contracts and leasing instruments.”

The authors rue that the heavy usage of the sale-based financing instrument murabahah has earned this practice the name ‘ murabahah syndrome.'

In their view, the reluctance of the institutions to risk-sharing instruments such as musharakah (equity partnership) and mudarabah (principal/agent partnership) comes in the way of reaping the benefits of globalisation.

“Islamic financial markets are dominated by Islamic banks and there are very limited activities in capital markets. Activities in capital markets are further limited to products that emulate conventional-style fixed-income ‘debt-like' securities and defeat the main goal and objective of Islamic financial principles.”

An economic system according to Islam is based on preservation of property rights, emphasising sanctity of contracts, ensuring justice in exchange and markets, expecting high ethical standards, sharing risks, and promoting social justice, the authors explain, in the opening chapter.

“The financial system is pivoted on the prohibition of riba, which includes payment and receipt of interest in all forms as understood in today's business world.”

Stating that the phrase ‘Islamic finance' is only about two to three decades old, the authors bemoan the common perception of this as a system where ‘interest' is prohibited; a simple description that is not only inaccurate but also a source of further confusion, they fret.

“The most significant implication of this prohibition is the removal of pure ‘debt-based' contracts from financial transactions.”

The Islamic financial system also encourages risk sharing, innovation, and entrepreneurship, and emphasises ‘materiality,' that is, it endorses a strong linkage between the real and the financial sector and promotes asset-based financing as opposed to pure lending-based financing, the authors inform.

They cite the contention of Islamic scholars that when the notions of economic justice and risk sharing are combined with other fundamentals principles of Islam, ‘it can lead to a financial system that is inclusive, efficient, and stable, and which promotes economic development.'

The financial crisis of 2007-09 could turn out to be the major catalyst for promoting the growth and globalisation of Islamic finance, the authors hope.

"The crisis has shown the inherent flaws of fractional reserve banking, debt leveraging, and the creation of money out of thin air. This crisis may be a major force for change in conventional finance toward greater reliance on equity at the expense of debt."And, Islamic finance can sustain its long-term growth, the authors foresee, if economies are liberalised, efficient institutions embraced, and consistent macroeconomic policies adopted. Studying the data on the flow of capital across borders, they postulate that global finance may be experiencing an early stage of the return to dominance of equity and risk sharing through the growth of Islamic financial techniques, as well as greater innovation of equity-based instruments within conventional finance. "And therein may be the initial seeds of convergence between Islamic and conventional finance."Recommended addition to the finance professionals' shelf.


(This article was published in the Business Line print edition dated December 24, 2009)
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