The Tense Dichotomy Between Shari’ah Compliance and the Economic Goals of an Islamic Bank by Camille Paldi

Introduction

This paper aims to explore the trade-off between Shari’ah compliance and economic goals in the development of Islamic financial products and various ways in which this tension can be resolved. In order to achieve this aim, I will examine the dilemma surrounding derivatives usage and the importance of risk management, asset-liability management, capital adequacy requirements, and liquidity to the economic goals of a bank. Islamic banks must compete in a conventional system, which limits the scope for true Shari’ah banking at this time as Islamic banks must mitigate risks and preserve its liquidity function to remain profitable. Furthermore, banks are restricted by capital adequacy regulations and constrained by the reality of existing in an interest-based system. The tense dichotomy between Shari’ah compliance and remaining solvent produces a proliferation of Shari’ah compliant products, which mimic conventional banking products as well as pressures banks to use conventional products.

The Push for Derivatives Usage and the Tense Dichotomy

Currently, Islamic finance imitates and directly uses conventional finance for product development. One way to illustrate this point is the push for the use of derivatives in the Islamic financial industry. The gut instinct of many financial experts and even surprisingly Islamic scholars such as Kamali and Obiyathulla would be to propose that Islamic banking utilize conventional products such as derivatives to mitigate risks, however, using derivatives violates the Shari’ah and can equally be used for speculation as well as hedging. In fact, even Warren Buffet takes a stronger stance against derivatives than many leading Islamic academics and refers to derivatives as “financial weapons of mass destruction, carrying dangers that, while now latent are potentially lethal” (AlSuwailem 2006: 36).

Kamali argues that instruments such as clearing houses reduce the uncertainty element of futures contracts and that the regulation of the trading activity combined with standardized contracts and the margin deposit and marked-tomarket procedure somehow allows futures the ability to evade the necessity of Shari’ah compliance, in particular, the prohibition on the sale of something, which one does not own or possess and the prohibition on taking possession prior to re-sale (qabd), sale of debt-for-debt (bai a’l-kali bi’l-kali) and sale of unbundled risks. According to Shari’ah, both counter-values must be present at the time of sale, or one now and one in the future, but not both in the future. Furthermore, futures, in particular, consist of a form of short-selling, which is not allowed under Shari’ah. Derivatives contracts are also highly uncertain consisting of prohibited gharar, which should in theory void the contracts.

Kamali purports that, “Hedgers provide actual goods and services to the economy and futures and options enable them to provide these goods and services more efficiently” (2000:39). It is questionable that hedgers provide real goods and services to the economy using options and futures as this involves the sale of unbundled risks, which separates the transaction from the real economy. Although Kamali argues that the option premium transforms the unbundled risk into a bundled risk as he says the premium price constitutes property (mal), Suwailem states that derivatives involve separating risk from economy activity, thereby opening the door for pure speculation and potentially leading to the destabilization of the entire global financial system (AlSuwailem 2006:40). Furthermore, the cost of doing business may actually go up as the business’s core activity may shift to speculation for profit, exposing real capital to major risks totally unrelated to their normal business (Al Suwailem 2006:53). Although Kamali addresses pertinent issues in Shari’ah law, he doesn’t give adequate weight to the importance of the rules found in Shari’ah and he fails to acknowledge the adverse effects of hedging and speculation and the long term costs to society.

Obiyathulla takes a similar stance to Kamali and argues that disallowing derivatives use in Islamic finance has adverse implications for the industry including value loss and inability to compete. However, Obiyathulla fails to understand that derivatives are in fact instruments of loss and not gain as 70% of derivatives trading ends up in loss (Al-Suwailem 2006:53) and therefore may be more detrimental to wealth creation than using other risk mitigation techniques. Furthermore, Obiyathulla does not acknowledge or admit in his analysis that the sale of something one does not own, unbundled risk, and debt- for- debt as well as transferring ownership without taking possession are expressly prohibited by the Shari’ah.

Derivatives result in the selling of unbundled risk, which leads to the distortion of asset prices, leading to negative impacts on real investment opportunities (Al-Suwailem 2006:53). Therefore, in actuality, derivatives will render businesses less competitive and profitable in the long run as well as adversely impact real investment opportunities, slowing the economy, and stunting growth. While I appreciate Obiyathulla’s passion for derivatives, he does not consider that risk mitigation solutions may be found within the Shari’ah itself.

It is dangerous for academics to suggest products on the basis of denying Qu’ranic prohibitions as this may lead to financial crises and the demise of the Islamic financial industry. Banks can actually use Shari’ah compliant risk mitigation and asset-liability management techniques as well as improve its capital adequacy, diversify product development and usage, and improve  liquidity in order to relieve tension between Shari’ah compliance and economic goals and promote Shari’ah exploration and production.

Capital Adequacy

In most countries, banks hold a minimum amount of capital, based on the risk embedded in their asset holding (Archer and Karim 2007:73). To be considered adequately capitalized, international banks in the G-10 countries are required to hold a minimum total capital (Tier 1 and Tier 2) equal to 8 percent of riskadjusted assets (Van Greuning and Iqbal 2008:223). Accordingly, banks with relatively risky assets hold a higher amount of capital than banks with less risky assets (Archer and Karim 2007:73). A bank would prefer to use modes of finance with lower capital charges in order to sustain solvency and lower its capital adequacy requirement. In order to improve its capital adequacy ratio, a bank can either increase its capital or reduce the risky assets it holds or both (Archer and Karim 2007:81). This induces Islamic banks to utilize the least risky, shortest term, and more liquid modes of finance leading to undiversified portfolios, which further hampers risk management. As a result, banks are exposed to specific sectors, raising the level of banking risk (Van Greuning and Iqbal 2008:149).

Risk management affects the bank’s level of capital it needs in relation to assets and deposits and the extent to which its structure affects its value (Archer and Karim 2007:72). A bank’s capital structure relates to the ratio of capital to deposits and the ratio of debt capital to equity capital. Its performance, in terms of return on equity capital, is influenced by its ability to calibrate the level of capital required (Greuning and Iqbal 2008: 220). Therefore, banks opt for short-term, liquid, low risk modes of finance in order to improve capital structure and lower its capital adequacy ratio. In addition to risk and capital structure management, providing for strong internal and external controls may create a more stable risk mitigation system.

Regulation

Furthermore, overall regulation of the Islamic banking industry requires improvement as it is not clear to which standard Islamic banks should follow. Basel II is required, IFSB is optional, and AAOIFI is only mandatory in certain countries. Banks may be confused as to which regulations must be followed and to what extent, creating unorganized havoc for the Islamic financial industry and indirectly constraining innovation. For example, the IFSB issued a capital adequacy standard based on the Basel II Standardized Approach with a similar approach to risk weights. However, the minimum capital adequacy requirements for both credit and market risks are set out for each of the Shari’ah compliant financing and investment instruments. It is not clear to what extent IFSB should be followed and what to do in the case of an overlap between IFSB and Basel. In addition, AAOIFI promulgated the Statement on the Purpose and Calculation of the Capital Adequacy Ratio for Islamic Banks, which takes into account the differences between deposit accounts in conventional banking and investment accounts in Islamic banking (Van Greuning and Iqbal 2008:59). However, AAOIFI standards are optional except for those countries, which have declared them mandatory. Standardizing capital adequacy regulations for Islamic banks and clarifying which guidelines and standards are optional versus binding and what to do in the case of overlap between Islamic and conventional standards would strengthen the regulatory regime for Islamic banking.

The Importance of a Secondary Market for Islamic Finance

This tension, which exists between Shari’ah compliance and the need to compete in a conventional system, can also be relieved through the creation of a secondary market for Islamic finance. The increased liquidity provided by such a market would relieve pressure on banks in fulfilling their liquidity function and lessen the pressure for risk mitigation while at the same time lowering the levels of required capital. Issuing sukuk reduces risk as it moves assets offbalance sheet and diversifies and lowers the cost of funding (Archer and Karim 2007:25).

Conclusion

This tense dichotomy between developing Shari’ah compliant and based products and competing in the conventional market can be resolved by strengthening the regulatory regime of and creating a secondary market for Islamic finance and producing Shari’ah based and compliant risk mitigation techniques, paying attention to the capital adequacy ratio, capital structure and asset-liability management of the bank, and strengthening internal and external controls in order to minimize capital requirements. In addition, banks should begin to diversify products for the purpose of risk mitigation. Furthermore, it is imperative that academics and scholars abandon the practice of justifying non-Shari’ah compliance for commercial competition reasons and instead devote their intellect to deciphering the many tools and products, which may be found in the Shari’ah itself.

Bibliography

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3. Al-Suwailem, Sami Ibrahim (2006), Hedging in Islamic Finance, Occasional Paper No. 10, Islamic Research and Training Institute, Islamic Development Bank Group, Jeddah, [http://www.irtipms.org/PubDetE.asp?pub=217].

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7. IFSB (2005), Capital Adequacy Standard for Institutions (Other Than Insurance Institutions) Offering Only Islamic Financial Services, Islamic Financial Services Board, Kuala Lumpur, [http://www.ifsb.org/standard/ifsb2.pdf].

8. Iqbal, Munawar and Tariqullah Khan (2005), Financial Engineering and Islamic Contracts, IRTI and the International Association of Islamic Economics, Jeddah.

9. Ismath Bacha, Obiyathulla (2004), ‘Value Preservation Through Risk Management: A Shari’ah Compliant Proposal for Equity Risk Management,’ The European Journal of Management and Public Policy, vol. 3, No. 1 (65 – 83).

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12. Van Greuning, Hennie and Zamir Iqbal (2008), Risk Analysis for Islamic Banks, World Bank, Washington D.C.

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