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Opalesque Islamic Finance Intelligence

Opinion Column: Existential Risk to Islamic Finance By Nikan Firoozye, Ph.D.

Tuesday, October 27, 2009

Paul Tillich, the theologian, in his seminal book, The Dynamics of Faith, claimed that faith was an essential component of life, and that this faith was underpinned by doubt; doubt was an essential component of faith and that doubt, overcome, was something that made believers firmer in their belief. While his main claims that faith was essential to life were in some ways completely contradictory to the basic tenets of existentialism (i.e., existence precedes essence, so in essence it may be possible to have life utterly meaningless), we present here what we consider to be existentialist risks to Islamic Finance.

These risks (expressed in different ways in the papers and authors listed below) have at times questioned the fundamental core of Islamic Finance and its current practice, although it is more in the spirit of Tillich that we hope to present these existential risks as something to lead to deeper introspection. Indeed it is through this questioning that hopefully leads to strengthening our resolve to pursue the core philosophy of Islamic Finance - characterized by the bans on riba, gharar and maysir.

Risk 1: "Conventional Derivatives are Better"
On the pareto-optimality of futures contracts over Islamic forward contracts: implications for the emerging Muslim economies
M. Shahid Ebrahima, Shafiqur Rahmanb

Journal of Economic Behavior & Organization, vol 56, 2005

A general equilibrium approach is used to demonstrate that: (i) futures contracting (on Islamically permissible commodities) is pareto-optimal over the Islamic forward contract of Bai' Salam; and (ii) both forms of contracting constitute a quasi-equity claim instead of debt (dayn) as construed by the majority of Islamic jurists. These results are of import as they: (i) remove a major hurdle against futures contracting by the Islamic jurists thereby enabling the renovation of the financial intermediation system of emerging Muslim economies; and (ii) demonstrate that the arbitrage principle needs to be re-examined under non-linear asset pricing.

Risk 2: "Conventional Derivatives are Islamic"
Islamic Commercial Law:An Analysis of Futures and Options
Mohammad Hashim Kamali

The Islamic Text Society, pp 262, 2001

Islamic Commercial Law: An Analysis of Futures and Options focuses on options and futures as trading tools and explores their validity from an Islamic point of view. Futures and options are a completely new phenomenon which has no parallel in Islamic commercial law. After reviewing the existing rules of Islamic law of contract and verifying their relevance or otherwise to futures trading, the author, Professor M H Kamali, advances a new perspective on the issue of futures and options based on an interpretation of the Qur'an and the Sunnah and referring to the principle of maslaha (consideration of public interest) as enshrined in the Shari'ah. Islamic Commercial Law consists of three parts. Part One is devoted to the description of futures trading and the understanding of operational procedures of futures and futures markets; Part Two investigates the issue of permissibility of futures trading in Islamic law and the underlying questions of risk-taking and speculation, which are of central concern to the topic. Part Three is devoted to an analysis of options. This work will be of use to anyone working on Islamic law, comparative law or working in Islamic banking.

Risk 3: "Simple Interest is Islamic"
Stipulation of Excess in Understanding and Misunderstanding Riba: The Al-Jassas Link
Mohammad Omar Farooq

Arab Law Quarterly, Vol. 21, pp. 285-316, 2007

An essential condition in the orthodox definition of riba is stipulated excess in a loan or debt. This essential condition is traced to al-Jassas. Understanding this issue of stipulated excess is critical to understanding riba. In this paper the stipulated excess in connection with al-Jassas as well as its implication for defining riba and prohibition of interest is examined. A critical examination of the subject shows that pre-Jassas discourse about riba did not include stipulated excess as an essential condition and al-Jassas' changing of the conditions in defining riba is not corroborated by the textual evidences he used.

Risk 4: "Islamic Contracts are not Incentive Compatible"
Incentive Compatibility of Islamic Financing
Humayon Dar

Handbook of Islamic Banking, Eds Kabir Hassan and Mervyn Lewis, 2007.

Islamic Contracts do not provide sufficient incentives - but no fear because the wa'd swap is here.

Risk 5: "Total Return Swaps (wa'd swaps) and Profit Return Swaps
(murabaha swaps)"
Pioneering Innovative Shari'a Compliant Solutions
Dr. Hussain Hamed Hassan

Deutsche Bank and Dar Al Istithmar

Completing the market for Islamic investors - the risk that non-permissible activities and financial ratio guidelines can be made trivial.

Risk 6: "Islamic Banking is Just Rent Seeking"
Mutuality as an Antidote to rent-seeking Shari'a Arbitrage in Islamic Finance
Professor Mahmoud El-Gamal

Rice University, 2005

An extensive crtique of the rent seeking and shariah arbitrage of modern practice. More of a traditionalist although one must admit he has a point. His idea of enacting change is certainly valid, although the proposed method is less than optimal. He would be much relieved to see the SSB model under each Central Bank (as in the Bank Negara Malaysia model) to counteract the conflict of interest inherent in the current SSB setup.

Risk 7: "Islamic Contracts are little different from Conventional ones"
In what ways does Islamic banking differ from conventional finance?
Mervyn K. Lewis

Journal of Islamic Economics, Banking and Finance, Vol 4, No 3, 2008

A critical overview of how "the adaptation of classical merchandising sales contracts for financing using deferred pricing contractual forms has changed the landscape" of Islamic finance. First in the critique is is how risk is transferred between traders and bankers - resulting in an economic cost/benefit scenario that is no different from what happens in conventional contacts. Second in the analysis is how "banks" profit rate comes from the charging of a difference between the deferred price and the spot price that can be 'benchmarked' to conventional interest rates", which is the root source of many snide remarks from outsiders in that there is little "substantive difference" between conventional and Islamic finance.

Risk 8: "Islamic Finance is merely a shell game and serves only isolationism"
Islam and Mammon:The Economic Predicaments of Islamism
Timur Kuran

Princeton University Press, 2005

Timur Kuran argues that the doctrine of Islamic economics is simplistic, incoherent, and largely irrelevant to present economic challenges. Observing that few Muslims take it seriously, he also finds that its practical applications have had no discernible effects on efficiency, growth, or poverty reduction. Why, then, has Islamic economics enjoyed any appeal at all? Kuran's answer is that the real purpose of Islamic economics has not been economic improvement but cultivation of a distinct Islamic identity to resist cultural globalization.

We present these various opinions here because they raise some serious questions which could shake the core of Islamic finance if they were indeed true. We must satisfy ourselves that conventional derivatives are not better, that they should not be Islamic because of some supposed superiority, and that they are not really Islamic merely by interpreting the rules correctly like Prof Kamali claims (in his absolutely fascinating and deep study). Similarly we must come to the conclusion that simple interest is no different from compound interest and it can be through Hadith alone (and the Prophet's abhorence of even accepting favours from borrowers, lest they be riba, let alone explicit markups) which should show the fallacy of such argumentation. If conventional were truly better and through the wonderful guise of Shariah transformation we could all get access to the wonders of conventional finance without having to lose the comfort of being halal, then Islam would truly be a burden, something that keeps us from opening normal savings accounts, taking out credit cards and mortgaging our homes, and we must really be such a sorry lot to have to pay for wa'd swaps just to ease our consciences. I think we can easily put this on the rubbish heap as an academic advertisement for structured product or a product of post-colonial envy of the west.

The latter criticisms from Professor El-Gamal shows some subtlety since it is more a question about the practice of Islamic Finance rather than the undertaking. Finally by the mere growth of Islamic Finance as an industry, with its newly found international appeal should give us confidence that it is meant to engage, not isolate.

We sincerely hope that you will satisfy yourselves of the vacuousness of some of the arguments, the hidden assumptions underlying others, and the use of rules to evade Maqasid. But in each of these, we can see a hint of a warning, something we must beware. It is either a mental trap to make us believe that the aim of IF is entirely wrong-headed, or believing that conventional methods are necessarily better, since this inferiority complex is the root of our wanting to emulate rather than to create. Perhaps the most positive aspect from all these points of view is the healthy debate that has been generated and the notion that the industry is not static but in a constant journey towards bettering itself.

Sincere thanks to Sayd Farooq for initiating this topic and Mahadzir Ahmad for his deep knowledge of relevant Hadith.

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