Islamic Financial Engineering and Prospects for Addressing the Credit Crunch - Research Proposal Example

Financial engineering and Islamic financial engineering and prospects for addressing the credit crunch (A dissertation prospectus) I. Introduction Bodie (1998, p. 1) defines conventional financial engineering as the design, production and pricing of innovations against risks from financial shocks. Financial engineering attempts to minimize or eliminate risks in financial instruments for market participants (Obaidullah 2005, p. 173). On the other hand, it can be shown that Islamic financial engineering addresses risks specific to its nature. Islamic financial engineering attempts to reduce the risks arising from Shari-ah non-compliance and the legal risks that can emerge as Muslims interact with the non-Muslim financial world. El-Gamal has pointed out that Islamic financial jurisprudence has aimed at enhancing human welfare but transaction costs have been substantially reduced rendering contract-based jurisprudence incoherent (2007, p. 1). El-Gamal (2007) provides a basis for Islamic financial engineering aiming for an Islamic law compliant as well as legal risk compliant financial instruments. An authority on the Islamic financial system is the Islamic Financial Services Board (IFSB) based in Kuala Lumpur, Malaysia. The Islamic Financial Services Board is an international standard-setting organization that seeks to promote stability of the Islamic financial services industry by issuing standards and guiding principles (IFSB 2009, p. 1). The member central banks/countries of the IFSB include Saudi Arabia, Malaysia, Bahrain, Iran, the Islamic Development Bank, Pakistan, Qatar, Singapore, Sudan, and the United Arab Emirates. We review the literature related to Islamic financial services. II. Review of Literature A key dimension of Islamic financial services pertains to Shari-ah governance. Unfortunately, according to IFSB documents (2009, p. 1), Shari-ah governance, despite being an often used word within the Islamic financial service institutions (IFSI), has never been “properly” defined. Nevertheless, Shari-ah governance is deemed to have been realized when a Shari-ah board believes so (IFSB 2009, p.1). El-Gamal (2003, p. 4), however, associates the Shari-ah with the Islamic Law. Following El-Gamal, Shari-ah compliance is therefore compliance with Islamic Law as judgment of competent authorities of the Shari-ah or the Islamic Laws. Gait and Worthington (2007, p. 27) clarified, however, that the main sources of the Shari-ah law are the Qu’ran, Hadith, Sunna, Ijma, Qiyas and Ijtihad. According to the latest available IFSB (2009) document on the Shari-ah, the Shari-ah board is usually composed of scholars on the Shari-ah (alternatively known as the Shari-ah Committee or the Shari-ah Supervisory Board) but the practice over the years is that corporate entities perform the board’s functions and the same applies to the Islamic Institutions for Financial Services (IIFS) themselves. According to the IFSB (2009), compliance with the Shari-ah had even meant that Shari-ah advisory firms could give the seal of compliance. Thus, the rationale for the work of the IFSB for instituting standards. Over several years, the Islamic Financial Services Board has developed three sets of guiding principles for the Islamic financial services industry (IFSB 2009. p.1). One set is composed of the guiding principles for institutions offering only Islamic financial services (known as IFSB-3 of 2006). The second set is composed of the principles of governance for Islamic collective investment schemes (known as IFSB-6 of 2008). Finally, the third set is composed of the principles of governance for Takāful (known as IFSB-8 of 2009). In the light of the need to define Islamic financial engineering, it is useful to describe the other key IFSBs. These are IFSB-1 and IFSB-5. IFSB-1 (2005) states the need for the Islamic Institutions for Financial Services to establish the “appropriate policy and infrastructure” to address legal risks and ensure compliance with the applicable rules of the Shari-ah (IFSB 2009, p. 1). IFSB-5 (2007) exhorts supervisory authorities to make sure that the appropriate systems are in place, including the system implied by a functioning Shari-ah board. It is also useful to refer to the IFSB (2009) document on how it defines Shari-ah Governance. According to the IFSB (2009, p. 2), Shari-ah governance refers to the “institutional and organisational arrangements” through which an Islamic Institution for Financial Services (IIFS) ensures an independent check of Shari-ah compliance through the following: 1. Issuance of relevant Sharia-ah pronouncements/resolutions by a competent Shari-ah authority over its operations 2. Dissemination of the Shari-ah pronouncements and resolutions to its personnel for guidance and compliance, and 3. Regular and verifiable review and audit with regard to compliance with the Shari-ah. The Shari-ah, just like the Jewish Halakhah, prohibits interest-based lending (El-Gamal 2007, p. 1). However, alternatives were provided (El-Gamal 2007, p. 1). For instance, El-Gamal (2007, p. 1) reported that instead of extending mortgage loan for a real estate, an Islamic creditor will buy the property and then sell it on credit to the customer and benchmark an implicit return on capital to the loan rates. El-Gamal reported (2007, p. 2) that all jurists of all the major schools of Islamic jurisprudence have allowed a credit price that is higher than the cash price that implies an interest rate even if lending based on interests is now allowed under Islamic jurisprudence (El-Gamal 2007, p. 2). Asserting Islamic jurisprudence for loans transacted with Islamic financial institutions, however, exposes both the creditor and debtor to legal risks. The courts in the non-Islamic countries will be deciding according to their own laws and not within the rules of the Shari-ah. These are competently discussed in El-Gamal (2007, p. 2-4). El Gamal argued that Islamic jurisprudence on financial services has to observe Qur’anic verse 16:90 that forbids unjust activities and Qur’anic verse 64:16 in which whatever commandments that were given in the Qur’an must be also interpreted in terms of maximizing benefits and minimising harm for men (2007, p. 4). El-Gamal argued that attaining the objectives of the Shari-ah requires the application of a benefit-analysis that is a cornerstone of the Islamic Law (2007, p. 4). For El Gamal (2007, p. 4), what matters most in Islamic contracts is economic substance and not the contract language or form. El-Gamal argued that similarly trading in forward, futures, options, and swaps can be justified under the Shari-ah even if majority of contemporary Islamic jurists have forbidden trading on these (2007, p. 10). For instance, El-Gamal argued that the ancient salam contract is similar to a forward contract (2007, p. 10). The call option is similar to an Islamic practice known as the urbun (2007, p. 10). Similarly, the other trading systems can be justified by assessing its similarity with the other trading systems allowed by the Shari-ah and Islamic brand-names may be used for the financial product as appropriate (2007, p. 10). Obaidullah (2005, p. 175-179) identified some of the problems that can arise in maintaining a Shari-ah compliant Islamic financial services as Muslims interact with the non-Muslim world: Prohibition of riba, gharar and qimar are central to Islamic law of contracts (p. 175). Further, while a small amount of gharar is tolerable, the prohibition is strongest on the issue of riba and qimar (p. 175). Based on this, the futures and options contracts will not be acceptable under the Islamic law because the financial products do not result in actual deliveries of the object of the trade (p. 175). Non-existent sale violates the Shari-ah based on the gharar (p. 177) Muslim scholars have been insisting on spot sales and not on settlements that can take place on a future date (p. 177). Potentially, Bai-Salam can be used for hedging but Muslim scholars say that this cannot be allowed for foreign currency (p. 179). According to Obaidullah, a potential exists to use creative financial engineering to create financial products compliant with Shari-ah (2005, p. 179). This is very important because Schmith (2008, p. 1) of the United States International Trade Administration, revealed that Islamic finance has grown tremendously and contributed more than US$530 billion in financial services worldwide by the end of 2006. Islamic global finance is so large such that Accenture, a global management consulting company, has already acquired the status of a mainstream finance. Further, MacEoin (2009) basically argued that legal problems related to the Shariah could be addressed in the United Kingdom and elsewhere via a functioning mediation system or laws. III. Methodology A. Research Problem The fundamental research problem that will be addressed by this work cover the following: How can we describe and compare Islamic from non-Islamic financial engineering in addressing the credit crunch? What are the problems, challenges, and prospects for Islamic engineering in helping address the credit crunch? B. Research Objectives 1. Identify and describe the financial instruments available in the Islamic world and compare them with those available in the non-Islamic world 2. Describe and compare current efforts to engineer financial instruments among Islamic and non-Islamic countries to address the credit crunch 3. Identify and describe the problems and challenges encountered in the said effort and determine prospects and opportunities for Islamic financial engineering C. Framework of Analysis This dissertation will combine both non-Islamic and Islamic perspectives in the analysis of financial instruments. The Islamic financial instruments will be assessed from the standpoint of non-Islamic financial engineering consistent with the perspective articulated by Bodie (1998) and other works on conventional financial engineering in the western world. Fundamentally, this means that the work will assess Islamic financial instruments from the perspective of how they protect both suppliers and consumers of financial instruments from financial shocks. Thus, the applicable tools for financial analysis will be employed on the Islamic financial instruments. At the same time, the most important thoughts of Islamic scholars will be factored in the analysis. The proposed dissertation will discuss how the most important scholars of Islam view Islamic financial engineering, covering also the “conservative” perspectives in the Islamic world or perspectives that articulate resistance to the emerging financial engineering that the Islamic Financial Services Board (IFSB) based in Malaysia has been trying to implement. The most or popular non-Islamic financial instruments will be also assessed from the perspective of the most important scholars of Islam. In particular, the dissertation will assess why the Islamic world has reservations against the financial instruments. The modes of analysis will likely produce insights useful to both non-Islamic and Islamic financial engineering. D. Data Gathering and Analysis The dissertation will employ document analysis as its primary mode of analysis for the work. Islamic financial documents will be obtained from the Islamic Financial Services Board as well as key financial institutions from the Islamic world. Similarly, the most popular financial instruments of the non-Islamic world will be obtained from key financial centres worldwide. E. Outline of the Dissertation The final dissertation write-up will have the following general outline: 1.0. Introduction 2.0. Review of Literature 3.0. Methodology 4.0. Results 4.1 Key financial instruments of the Islamic and non-Islamic Worlds 4.2. Current efforts in non-Islamic and Islamic Financial Engineering 4.3. Problems, Challenges, and Prospects 4.4. Opportunities 5.0. Conclusions and Recommendations References Accenture. 2009. Islamic finance: From niche to mainstream. Bodie, Z. 1999. Investment management and technology: Past, present, and future. Paper presented, Brookings-Wharton Conference on “The effect of technology on the financial sector.” El-Gamal, M. 2003. Islamic financial engineering vs. architecture. Houston: Rice University Powerpoint Slides. Available from: http://www.ruf.rice.edu/~elgamal/files/engineer-architect.pdf [Accessed 14 July 2010]. El-Gamal, M. 2007. Incoherence of contract-based Islamic financial jurisprudence in the age of financial engineering. Houston: Rice University. Available from: http://www.ruf.rice.edu/~elgamal/files/Incoherence.pdf [Accessed 14 July 2010]. Gait, A. and Worthington, A. 2007. A primer on Islamic Finance: Definitions, sources, principles, and methods. University of Wollonqong: Faculty of Commerce Papers. Islamic Financial Services Board (IFSB). 2009 (May). Exposure draft: Guiding Principles on Shari-ah Governance System. Kuala Lumpur: Islamic Financial Services Board. Jobst, A. 2007. The economics of Islamic finance and securitization. IMF Working Paper 07-117. Washington: International Monetary Fund. MacEoin, D. 2009. Sharia law or one law for all. London: Civitas. Obaidullah, M. 2005. Islamic financial services. Jeddah, Saudi Arabia: Islamic Economics Research Center, King Abulaziz University. Schmith, S. 2008. Trends in Islamic finance regulations. US Department of Commerce: International Trade Administration. Read More