ISLAMIC FINANCE: FUTURE CHALLENGES
SHEIKH SALEH KAMEL
The concept of participation-based banking has passed a critical phase of life, it has gone beyond the time of preaching glad tidings of the new banking system and has entered the stage of operations, at a national and international level, whether in the investment or service sectors.
The development of the new system has motivated traditional bankers to attain new horizons of innovation instead of dealing in currencies and receiving fixed rates.
Major Western banks have begun to enter and participate in direct investments, productive operations and risk-taking. Many commercial banks in the Arab and Islamic world have opened outlets for banking practices based on profit-and-loss participation and the application of well-known Islamic finance and investment modes.
This trend should be welcomed as a true reflection of public acceptance for this type of business. It opens a wide field for the dissemination of the new modes of finance based on the removal of usury.
The use of the term “Islamic banking” is in many ways imprecise, because of the long-forgotten principles, namely that usury is forbidden in Christianity and in Judaism as well as in Islam. This has generally been forgotten by Christians and Jews. Consequently, the current concept that usury is acceptable, ignores this injunction. The principle of the removal of usury from financial transactions is a principle of all religions and not only of Islam.
The widening of the Islamic banking domain through the adoption of the system by Western and Arab banks, either totally or partially, is a welcome development and there is no Sharia or technical limit to co-operation between the Islamic banks and their conventional counterparts in different fields.
For example, Dallah Albaraka works closely with conventional banks on Sharia principles, and through this co-operation, has satisfied the needs of many Islamic countries by importing for them basic commodities such as petroleum, wheat and rice.
If such co-operation is adopted by major banking groups on a large scale, it will bring benefits through the activation and development of Islamic financial instruments, as well as curbing the speculative use of new financial instruments and directing them towards real productive activities.
Recently developed financial instruments, known as “derivatives”, are still in the phase of experimentation and development and are characterised with technical complexities. They are generally used for risk management and include options, futures, swaps and caps, as well as other types of so-called “financial engineering”. These derivatives need to be referred to in the light of principles governing Islamic investments, by raising the following issues.
Considering the prevailing conditions of Islamic countries, which should be developed first: primary or secondary markets? Within the framework of Islamic financial institutions’ compliance with the Sharia, is it permitted to issue and circulate all types of derivatives? Finally, within the sphere of priorities and preferences of Islamic investment principles, can modern instruments be given a primary role, justifying expansion in their use?
The innovation and use of these instruments have led to the development of a secondary market. This was a natural evolution considering the circumstances and realities of the advanced industrial economies, and created a huge productivity base and participated in making real investment opportunities, which in turn expanded the primary market base in terms of quantity and quality.
This natural attitude towards the development of a secondary market was normal in order to serve such a solid productivity base. However, if serious discrepancies and speculative practices prevail in the secondary market. Western economies are able to absorb any sudden shocks without sending whole economies into complete collapse.
There is an urgent need in the developing world in general, and in Islamic and Arab countries in particular, to provide support to primary markets by promoting new issues, managing subscription operations therein, covering commitments and attracting individual and institutional savings and directing them towards new productive projects.
A major and vital criterion by which to judge the extent of financial market success, is its developmental function. This criterion, in particular conditions, is given priority over turnover size, which is considered in Western markets as the success indicator for financial markets. Encouragement of primary markets leads to the creation of new jobs and enhancement of the productivity base, while the secondary market creates only a demand for marginal jobs.
The secondai7 market should be active enough to realise the interest of savers in selling and purchasing securities to earn revenues therefrom or changing their investments for liquidation purposes. However, the encouragement of the secondary market, in the absence of a broad-based and diversified primary market, would result in increased circulation of a limited number of securities, leading to price rises and speculative transactions, as well as widely differing profits, to the extent that, at a national level, the economy would be negatively effected. Such examples are still current and noticeable.
For these reasons, the development of a secondary market should be preceded by, or be contemporary with, the revival and innovation of instruments sending the primary market, in order to satisfy the real needs and requirements of developing countries.
Financial derivatives designed to protect export revenues from foreign exchange fluctuations require the existence of an export-orientated economy, as well as positive merits in terms of productivity powers and an international exchange rate in their favour. Financial derivatives which intend to protect firms from fluctuations in the rate of interest are of vital importance for creditors’ economic powers and debtors’ institutions. However, it is doubtful whether other entities which seek aid and loans can make use of such derivatives.
Accordingly, the strengthening of the productivity base, as well as expansion in investment opportunities, establishment of new projects and the enhancement of investment and employment, which are all within the scope of the primary market, represent the major guarantees for the creation of a successful secondary market capable of serving the urgent needs and demands of the national economy.
Islamic financial institutions should not be self-absorbed entities, but should rather be open-minded, making use of human experiences in a selective manner consistent with their basic commitments. They should further continue to use more innovations in the banking and finance fields. They should be selective, choosing between Western norms and matching them with Sharia requirements and particular economic and social circumstances.
There are Sharia precautions against certain mechanisms and methods, usually because they are accompanied by economic and social risk. Such defects can often be corrected to enable co-operation between Islamic and conventional institutions in the field of new instruments.
A major part of derivatives operates within the range and scope of interest rates. One such example is the cap option, where the purchaser of the option agrees with the buyer to apply a fixed interest rate at times of loan renewal during its term, regardless of the prevailing rates of interest. These options are liquidated on a cash basis, where profit and loss are calculated depending on the variance of the current rate of interest on liquidation day and the agreed-upon rate respectively.
There are also floor options, where the minimum rate of interest to be applied in renewing the loan term is fixed. The collar option is a mixture of cap, floor and interest rate options on forward contracts and the swaps of interest rates, swapping of loans entered on variable rates of interest with loans entered on variable rates of interest. Without referring to the complexities and details of such instruments, they are all related to interest rates and their variations.
As dealing with interest is prohibited in Islamic institutions, the use of such instruments and derivatives is eliminated. However, experts can decide the possibility of making use of these in protection and coverage of the profits of Murabaha and Istisna contracts. The implementation of such transactions through Libor should not be cautioned. However, Libor does passively reflect on the credit-worthiness of Islamic banking. On various occasions. Islamic institutions have been called on to exert a common effort to design a rate for profit expectation to supersede Libor, but the effort has so far been weak.
The contract of futures requires both parties to agree upon entering a transaction which will be implemented at a later date, without possession by the seller of the subject commodity. Both parties wait until the time of liquidation to receive or pay the difference between rates on contract date and liquidation date respectively. Commodities transacted can either be real, such as coffee and cotton, or securities, such as shares, bonds or amounts in different currencies. Such contracts are prohibited by the Sharia, through the Hadith, “Do not sell what you do not have”.
This principle is a rational economic directive designed to protect the market from artificial contracts and transactions as well as from deep speculations of the type that resulted in inconsistency and adventurous activities.
Option markets, in their different types, have received remarkable acceptance. The mechanism involves the existence of a seller and a purchaser of an option. The party whose price expectations and predictions are more accurate on liquidation day is the winning party of the transaction, while the other is the loser Many writers who have contributed to the issue are of the opinion that dealers in options take big risks. This type of dealing is mere gambling introduced in a new form.
Scholars disapprove of options, because the option is not a commodity evaluated into money, to justify being sold and bought. Defenders of option markets argue that it depends on analysis, evaluation, observation of expectation, procedures and professional principles as well as a good acquaintance with the factors governing the market. However, if this is true, why are losses incurred by huge organisations retaining financial, economic, political and mass media experts?
There is a long list of other transactions, including margin dealing, which is dependent on the rate of interest, as well as future swaps of currencies, which are unanimously prohibited according to the Sharia. Most derivatives and financial instruments devised in Western markets tend to transfer risk to others. The Islamic investment method depends on risk-taking, risks which result in added value to the community. Islam considers any economic transaction in terms of benefits that can be reaped by the community and gives lesser importance to individual earnings. The scale of preferences and priorities is arranged according to the overall added value to the community.
Although currency dealing is allowed, trade and speculation in currencies are not considered as rational investment behaviour This principle is reflected in Zakat, where the rate is higher on individual activities and those which are lower developmental in nature, such as commerce, while the rate is less on activities which provide more jobs and participate effectively in economic development, such as industry and agriculture. Every asset can be subject to Zakat, depending on the purpose of its possession. If you keep a share for investment and make use of its annual return, only the return is subject to Zakat, while if it is used for trade and speculation, the Zakat is charged on the principle as well as on the profit.
Islamic financial institutions welcome dealing with conventional banks domestically and abroad, without any reservations other than observance of Sharia requirements and serving the interests of our countries and people.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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