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Opalesque Islamic Finance Intelligence

Opinion Column: Zaid Ibrahim Report on Islamic Finance Blake Goud

Friday, July 30, 2010

 Blake Goud is the principal of Sharing Risk dot Org (see reference link), he is an expert researcher on Islamic finance as well as a freelance journalist with a monthly column in Business Islamica magazine and the US correspondent for Islamic Business & Finance magazine. His areas of focus within Islamic finance are its growth within non-Muslim-majority countries, microfinance and the interaction of Islamic finance with other forms of ethical finance. He currently serves as Chief Compliance Officer of Marquam Capital, an investment advisory firm specializing in ethical investing.

The Malaysian law firm Zaid Ibrahim & Company recently released a report (see reference link) entitled "Demystifying Islamic Finance" which reviews 14 misconceptions about Islamic finance as well as 10 value propositions. For people familiar with Islamic finance, the report does not provide anything new or controversial. However, it is a useful resource for anyone interested in promoting Islamic finance in regions where it is not common or well understood. For this it should be commended because there are no other resources that present similar information in such a compact and readable format.

Several of the misconceptions (for example that Islamic finance is terrorist financing, it is for Muslims only and that it is welfare finance) are commonly enough understood as false that they need no detailed explanation. However, there are several that deserve a brief overview. The report clarifies the debate about standardization in Islamic finance by pointing out the wide areas where there is standardization. For example, many Islamic banks' products are nearly identical globally. The contentious areas of standardization remain under debate but many aspects of Islamic finance are standardized, for example accounting and auditing standards developed by AAOIFI.
 

Another area where the report provides a good overview is dealing with the idea that Islamic finance is intrinsically superior to the conventional financial industry; that it is less risky, has lower costs of funds and is immune from crisis and unethical dealings. Islamic finance may strive to be more ethically-driven than the conventional financial industry, but that depends on individuals' behavior. There is no guarantee that Islamic finance practitioners will behave in a more ethical way. A recent article from July 2, 2010 in Reuters described the difficulty of Islamic finance growing in Egypt in part because there were many frauds in the 1980s by investment companies that labelled themselves as 'Islamic'.

Just as Islamic finance depends on ethical behavior by its practitioners, it is also subject to excessive risk taking and the bubble mentality which recently drew financial institutions, both conventional and Islamic, into an unsustainable finance bubble that popped following the global financial crisis. The Islamic finance industry may avoid the most leveraged areas that fell furthest in the financial crisis, collateralized mortgage obligations (CMOs), credit default swaps (CDS) and the rest of the alphabet soup of highly leveraged products.

Even institutions that minimized their participation in overvalued property markets in some parts of the GCC were hurt in the financial crisis because of their linkage with the real economy. Once the financial crisis (where they saw liquidity dry up) abated, the economic recession reduced the value of many investments outside of the bubble areas and this has affected the Islamic financial industry and caused substantial losses and reduction in profits of these institutions.

15 Most Frequent Misconceptions of Islamic Finance

1. Terrorism Finance
2. For Muslims Only
3. Replica of Conventional Finance
4. Primitive Methods of Doing Finance
5. No Standardisation of Best Practices
6. More/(Less) Risky than Conventional Finance
7. Lower/Higher Cost of Funds
8. 'Welfare' Finance
9. No Guarantee
10. Driven Purely by Oil Boom
11. Immune from Any Unethical Practice
12. Immune from the Global Financial Crisis
13. Governed only by Shariah
14. Requires Minimal Changes to legal & Regulatory Framework
15. To Replace Conventional System, aimed towards Islam's world domination
Source: Zaid Ibrahim & Co report (see reference link)

In the second section of the report, Madzlan Hussain, the author and a lawyer at Zaid Ibrahim, describes the value propositions that Islamic finance creates compared with conventional finance. In contrast to the description and refutation of misconceptions, I found some of the value propositions lacking. There were some-promoting cross border trade and flows of funds and financial inclusion of an underserved segment of the community, closer support to the real economy-that are clear. However, other value propositions are less certain.

For example, the report says that there is more diversification of risk in Islamic finance. In part, this section describes the development within Islamic finance to create more avenues for diversification; the industry still lacks well developed, deep secondary markets for fixed income outside of Malaysia. This ties in with another value proposition of Islamic finance as a new asset class. Islamic finance may become a new asset class where risks and rewards are shared in a different method compared with conventional finance. However, today most Islamic financial products are designed to largely replicate a conventional product: sukuk replicate the risk/reward structure of conventional bonds, the Tahawwut Master Agreement for Shari'ah-compliant derivatives tries to create an Islamic alternative to the ISDA Master Agreement for conventional derivatives.

Another value proposition is that Islamic finance provides greater systemic stability than conventional finance. Just as derivatives were thought to spread risk across the system to reduce instability, the risk-sharing principles in Islamic finance may not function exactly as envisioned in a future crisis. Islamic banks and other financial institutions are still vulnerable to runs by depositors and drying up of liquidity. The systemic risks, which were described in detail in a Islamic Financial Standards Board-Islamic Development Bank-Islamic Research & Training Institute report may be more acute because there is not well developed Shari'ah-compliant deposit insurance or interbank money markets.

10 Main Value Propositions of Islamic Finance
1. Adherence to Shariah, Subscribing to Higher Ethical Ideals
2. Promoting Crossborder Trade and Flow of Funds
3. Financial Inclusions of the Underserved Segments of the Community
4. Expansion of a New Asset Class
5. More Diversification of Risks
6. Unlocking the Values of Idle Assets
7. Job Creation
8. Sound Risk Management
9. Closer Support to Real economy
10. Systemic Stability
Source: Zaid Ibrahim & Co report (see reference link)


The level of depth of these criticisms are outside of the scope of the Zaid Ibrahim report, which was aimed at people unfamiliar with Islamic finance. It is also much easier to correct misconceptions than it is to describe in brief constructive value propositions that Islamic finance can provide. As such, the report is a valuable starting point and will hopefully create greater awareness of Islamic finance, reduce misunderstanding of how Islamic finance works and what it can and cannot provide, and lead to further discussion of the value proposition of Islamic finance.


Your feedback and comments are very important to us, please feel free to contact the author via email.
 



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