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Opalesque Islamic Finance Intelligence

Editor's Note: The Shariah Compliance of Teldar Paper by Bernardo Vizcaino, CAIA

Monday, October 04, 2010

It seems that the decay in the current financial system is pegged to the notion that bankers got greedy, way too greedy for their own good. 'Greed is good' is perhaps one of the most cited movie lines ever, and it was reflective of the individualism and pageantry of the 80's. It has returned (alongside a movie sequel), this time to signify the collective excess of the financial industry, an excess that borders on the sinister. The character of Gordon Gekko, who utters the infamous phrase, has become one of the great villains of popular culture. It is said that he is based on a couple of individuals from that decade - among them a corporate raider, an arbitrageur, as well as a junk bond king. While we could point to a handful of Gekkos in the 80's, it now seems that the current financial industry is saturated with many different versions of himself.

Feet on the ground, Head in the sky

Gekko made a strong case for greed - whether it is for life, love, money or knowledge. His argument though carried some caveats. First of all, our understanding of greed has to be differentiated from that which is aimed towards a basic need/necessity and the other geared towards a want or desire. Consider how greed can be qualified: short-term greed versus long-term greed; unrepentant greed versus greed with a conscience; individualistic greed versus greed on behalf of the community. You can talk about needs and wants, but they are all driven by some level of greed. Lets consider another human emotion - love. Love for country, love for war, love for cigarettes. So if love can be bad... can certain types of greed be good? Can greed exhibit benevolence, good intentions, can greed grow a conscience?

Greed in its traditional definition is selfish, excessive, uncontrolled, but what if we could channel greed towards an unselfish, moderated and regulated purpose? Would the opposite make any sense - is all greed bad? If so, we must query the validity of our goals in the financial markets: capital appreciation, wealth accumulation, and even capital protection - they are all borne from differing levels of greed. Islamic banks should stop announcing quarterly profits, they should merely focus on break-even points. Perhaps Gekko should have said 'Greed is more or less ok, sometimes, it depends' although this would have been far less convincing to his audience.

The definition of greed has been refined over time. The notion of efficient markets was always considered to be achievable when individuals sought the best outcome for themselves in an open market (i.e. they are motivated by their individual greed), but this has been revisited in modern financial circles with the concept of individuals seeking the best outcome for themselves and the group in less than efficient markets (i.e. they should make their decisions based on individual greed and a collective greed). Thus the former greed of Adam Smith's efficient markets has been replaced with the latter greed suggested by the Nash Equilibrium. Greed has been qualified, perhaps sanitized, but it is still greed.

Cover up the blank spots, Hit me on the Head

Another aspect of Gekko's utterance is that it was not meant as a one-liner, it must be digested in the context of his entire speech. What was Gekko trying to achieve that day during the shareholder meeting of Teldar Paper (the fictional company that he is aiming to restructure)? He was positioning himself as the missing link between shareholders (apparently disenfranchised with how the company is being run) and management in the form of the board of directors (vilified as being focused on their own bonuses rather than the long term viability and financial health of Teldar Paper). It all boils down to governance and how corporations respond to their stakeholders - whether these are shareholders, creditors, or even society at large. Would we vilify Gekko if he had attempted the same speech at the shareholder meeting of Bear Stearns or Lehman Brothers? Greed, it seems, is relative as well.

Curiously, Gekko was trying to play the role that regulators such as the SEC are eagerly trying to address today. He was presenting himself as a sentinel of the corporate entity, one that surveils and reviews everything that is being done inside Teldar Paper and calls into question any product, practice or action if it is not aligned with the interests of its shareholders.Regulators cannot fill that role as they must remain at arms-length with market participants, so who can fill this void? Is there any corporate instrument that can be put in place to pro-actively monitor the corporate entity, thus ensuring the company avoids practices that are non-compliant with its own charter, controlling and regularizing the ethos of the corporation? Who besides Gekko can do this? Who can be tasked with this duty of care towards not only shareholders but the community as a whole? The answer is closer than you can imagine.

Blue Horseshoe Still Loves Anacot Steel

The concept of a Shariah Supervisory Board (SSB) can blend the best aspects identified above. All we need to do is rethink our understanding of an SSB: an ethical third-party committee. We can then position an SSB as an extension of a regulator in that it abides by specific rules and dictates. This can be the missing link between headless corporations and disenfranchised stakeholders (which would include investors, consumers and the community). The SSB is a device that can be at the forefront of the emerging school of Enterprise Risk Management. It is unfortunate that an SSB and an ERM methodology have yet to find each other, but this should not stop us from considering how the concept of an SSB would impact the incentive structure and the internal mechanics of a corporation.

Bear Stearns and Lehman Brothers might still be here today (probably to our dismay), their implosion avoided had they implemented an ethical supervisory board. In as much as some of their financial instruments and several of their corporate practices could have been vetoed by a panel of industry experts (be that academics, former industry bosses, professional consultants, etc). In theory they could have deemed many of their products as either toxic, too risky, or simply representing the wrong kind of greed (i.e. too much short term greed and not enough long term greed). This could equally apply to oil companies or car manufacturers, imagine having a third-party supervisory body that avoids certain practices (i.e. renting leaky oil rigs in the Louisiana bayou) or encourages others (designing more fuel-efficient or alternative-energy vehicles).

Gekko was partially right, although his arguments were incomplete. In his speech in front of the Teldar Paper board he defends himself as "not the destroyer of companies" but rather "a liberator of them". What the market needs is a new set of eyes so that these liberated/liberalized companies remain truthful to their corporate spirit and are reminded of their social responsibilities. The grand opportunity for the Islamic finance industry is that it is not sitting idle on this instrument of corporate governance, instead the SSB model is being revised, questioned, strengthenedand revitalized. The current discussions surrounding Scholar independence, conflicts of interest, duties and responsibilities should be given a new boost, as this is a rough diamond that the industry can polish for implementation elsewhere. The SSB model is being primed for export beyond Islamic finance. Regardless of whether greed is good or bad, the development of the SSB as a corporate governance mechanism is most certainly a good thing.

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