Name: Xinxin Yuan
Student Number: H00292979
Professor’s Name: Robbie Mochrie
Course: Emerging Financial Market (C21EF)
Date: March 29nd, 2019
Word Count: 2570
Islamic Financial Institutions
Ideally, Islamic Financial Institutions (IFI) are structured to comply with Islamic Law. The underlying tenets that regulate IFISs are profit sharing and mutual risk among stakeholders; every transaction is based on real assets or business activity, and guarantee of fairness to all parties. Generally, all financial institutions are vulnerable to a significant number of risks namely: operational risks, market risks, liquidity risks, and credit risks. Nonetheless, since IFIs limit themselves to ethical and religious underpinning, due to the dynamics of their operations the unique requirements expose the Islamic banking sector to special risks such as displaced commercial risks, equity investment risk, Shariah non-compliance risk, murabahah price risk just to name a few. IFI thrive due to the adoption of profit loss sharing (PLS) which in turn minimize risk to manageable levels (Cobham 3). In this case, banking institutions treat financing and deposits are separate entities to mitigate risks since to some extent risks are inevitable. From this illustration, it is evident that risk management mechanisms in the Islamic banking system are applied more compared to the conventional banking system.
Notably, Islamic finance has introduced various risk management strategies to ensure that they protect its clients from excessive risk or trade at risk. Aiming to create a thriving economy, IFIs endeavours to establish contracts that trade in real assets and returns that match the risks (Wilson 86). In this view, Islamic finance outlaws gambling, usury, illegal goods, and uncertainty. Similarly, it encourages a financial system that promotes equal welfare and justice for all parties at the micro and macro levels. Islamic banks adopt a value proposition that depends on numerous requirements such as observing Maqasid al-Shariah, forms the basis of Islamic finance. It is vital to note that the success of IFIs over the decades has been attributed to Shariah contracts. In this view, various scholars argue that the proper creation of a contract accomplishes its primary objectives by default. Contracts entail the transfer of value among the concerned parties as the sole legal requirement of sealing a contract. Scholars maintain that a contract should contain a binding force that ensures that parties’ rights are safeguarded and hardship issues discussed amicably (Cobham 242). On the contrary, the structure of the contract is subject to debate among scholars that includes Qayyim al-Jawziyyah and Ibn Taymiyyah. The former dedicates the whole section of hiyal to analyzes some aspects within the elements terming them as unethical (Ray 51). Moreover, one of the Sunni schools invalidates Murabahah contending that the entire business is centered on a seller exchanging goods that do not belong to him or her.
Some Shariah scholars have tried to pinpoint the aims of Shariah contracts in modern Islamic financial practice. A scholar such as Abu Ghuddah emphasize the general tenets of contracts as just, fair, benevolent, and secure for partners. Regardless of the importance of the goals, they seemed to have been borrowed from a fiqh perspective. Shariah contract is established under the following principles namely ethical dimension, satisfaction, and equitable rights. Nonetheless, the values are interrelated with the aims of Shariah contracts; an interdependence that may obscure the difference between objectives and principles. Qahf also claims that some principles such as the debt and equity contract are vague (Zulkhibri 241). On the other hand, an Islamic scholar such as Sami al-Suwaylim is a committed defender of the element of substance as opposed to form of Islamic finance. In this view, he opposed the contract of sale of debt to pay an outstanding debt and wealth circulation. Similarly, the scholar considers organized tawarruq and inah as ploys to evade the ban of riba, in spite of the combined contract implemented separately. Preslon and John (2007) oppose this approach so long as the property under tawarruq does not return to the initial seller. Noting the divergent views in Islamic contracts, the Accounting and Auditing Organization for Islamic Financial Organization (AAOIFI) authenticates Islamic hire purchase (El-Gamal 186). Rafiq al-Misri, nevertheless, considers hire purchase as illegal since it amounts to a loan with interest thereby undercutting Maqasid Shariah principles.
Mutual financial institutions often offer their clients with better financial services as compared to insurance and banking companies. Essentially, joint financial corporations deliver the same credit and risk products and services that are crucial for the economic well-being of the clients and the country in general. Nonetheless, they offer such services in a way that it does not exacerbate financial risk. This strategy reduces risk levels, which in turn make financial corporations resilient particularly during financial shocks such as during the Great Depression period that saw many countries in the west and Europe cede to economic sabotage. It is important to note that the aim to ban of gharar and riba is to minimize trade risk. In this view, the spirit of Islamic banking permits transfer of risk and credit only within financial transaction such as leases, partnerships, and sales. Such restrictions minimize the level of risk-taking in business dealings that in turn allow regulated risk-taking thus boosting economic growth and investment (Abedifar, Philip and Amine 2040). Limiting risk levels minimizes systemic and individual risks of bankruptcy and unprecedented fluctuations. Islamic finance focuses on contract forms without altering the substance of basic economic transactions that essentially remain sales of risks and credits. Such contractual limitations and modifications remain important to Islamic financial transactions for the future, which in turn reduce excessive risk or trade in risk thereby making financial institutions more resilient.
Over the decades, Islamic banking and finance has evolved to become a worldwide financial system. The successes of IFIs are attributed to various principles that over the years have made the institutions to economic shocks. In this view, IFIs do not act as pure lenders; they are involved in investment and trade operations and adopt the strategy of direct ownership of real assets (Nathan and Chris 390). Owning real assets regulates uncontrolled credit expansion speculation. Even though banking institutions document and account for the debt receivables, they experience challenges when offloading debt receivables, as a significant number of Shariah scholars forbid debt trading.
Ideally, the IFIs derives its resilience from Shariah law that bans the leasing or selling a product that one does not possess. It also excludes speculative short selling within the Islamic banking and finance institutions. The Shariah principles promote responsibility and discipline that in turn guarantees financial stability. Nevertheless, the Islamic banking and finance sector is vulnerable to risks and economic crisis because of some causes. First, Islamic financial industry is directly linked to the real estate sector; therefore, any unprecedented developments experienced in the industry will affect business performance of the financial institutions in the absence of effective and robust risk management measures (Ullah and Dima 625). Due to this, risk in the real estate sector is slowing declining in the past decade yet risks within the financial industry have experienced a sharp increase. The findings suggest that the financial industry encounter minimal risks and instability compared to other non-financial companies. Secondly, financial institutions may be tempted to adopt speculative investment policies that expose businesses to extreme risks but promise higher returns.
To regulate corporate greed within the IFIs and enhance resiliency, it is mandatory for such institutions to adopt and implement prudent risk management measures that will, in turn, protect the Islamic financial system. In this view, the Islamic Financial Services Board (IFSB) proposes, adapt, and oversees financial standards especially those covering corporate governance, risk management, market discipline, and capital adequacy (Waemustafa, and Azrul 458). Examples of the models and practices that protect the IFIs include (a) amendment of risks in Islamic banking and finance. (b) A banking model that incorporates commercial banking systems, asset management, and investment banking. (c) Financial firms concentrate on investing in the real estate sector instead of indulging in speculative trading. (d) Proper management of investment accounts encourages investor protection, transparency, specific governance, and depositor protection. To enhance resilience within the IFIs, the IFSB oversees its standards to reduce fiduciary risk towards investment and current account holders.
Mostly, to minimize excessive risks or trade in risks in Islamic banking institutions, the management, and respective governments have adopted Dynamic Asset Allocation (DAA) with the aim of enhancing the return profile (Basak, and Georgy 3000). The strategy practically positions the financial institutions’ portfolio in favour of asset classes. In most cases, the risk premium is higher compared to equilibrium assumptions integrated into asset allocation. This method requires financial managers to subscribe to various investment beliefs such as the excess risks, returns vary in time, and the excess returns are predictable. In other words, Islamic banking and finance objective of integrating DAA is to minimize overall portfolio risk at a time when the assets are abnormally high in the stock market.
The DAA strategy is appealing investors especially to those that engage long –term investments. It is mainly preferred because it stabilizes downside risk of the investments particularly in a volatile market environment such as the Great Depression of 2008. Nonetheless, DAA obligates the investors to make decisions against the common assertions. Additionally, the model signal might be correct but the timing of the fair value is mostly unpredictable, and the choices may generate losses in the short-term (Maghyereh, and Basel 250). Thus, the cons of this strategy need to be addressed in the governance framework of the DAA. Often, to increase profit margin and minimize the uncertainty in business, investors will most likely anticipate valuation signals to reach optimal levels before making informed decisions. DAA presents implementation challenges as transactions occur rarely; therefore opportunities will be few minimizing the profits for a significant percentage of investors.
Sukuk is a unique bond adopted in Islamic bonding and finance. A significant number of Islamic scholars consider it as an alternative tool in the Islamic financial corporations. The bond is primarily used to support efficient allocation in the global market. The securities comply with the Shariah screening criteria and its principles. Asset allocation is supported through Islamic Equities to reduce the chances of funds being affected by price fluctuations and volatilities in the Muslim world and the global stock markets in general (Godlewski, and Rima, 45). The primary role of Shariah screening is to minimise the number of stocks to available Shariah-compliant investors thereby improving the efficiency of asset allocation in a market-oriented economy. The strategy of adopting equities and funds in Islamic banking and finance has outperformed the conventional means of banking primarily due to the unique sectorial composition of IFIs.
Efficient asset allocation through the availability of Islamic equity indices has attributed to the growth of the Islamic funds such that these institutions offer funds to investors. Currency depreciation coupled with the global market recession in 2015 has affected the net asset value of Islamic reserves, particularly in the U.S Dollar terms. Due to the success of this strategy, the Assets under Management sector’s Shariah-compliant reserve has grown from 74 in 2014 to 76 U.S billion dollars in 2016 (Elsiefy 20). The gains have been achieved despite the depressed and volatile global economic cycle. In this view, Saudi Arabia tops the Islamic fund industry with the largest share of 41% of the overall Asset under management while closely followed by Malaysia at 30% (Ismail, Shabri, and Rossazana 100). However, the global merger strategy adopted in Europe and the Western world may most likely affect the performance of the Islamic fund.
The adoption of Islamic insurance popularly referred to as Takaful has effectively assisted in efficient asset allocation in Islamic banking and finance. Financial institutions have adopted Takaful with the goal of risk sharing. Ideally, a financial corporation reimburses funds to a group of selected members that have mutually agreed to support each other against losses from any business venture. A designated Takaful operator after that manages the money on behalf of other members. The operator earns his or her dues on the profit and loss sharing basis. It is important to note that a financial sector with an efficient Takaful system attributes to the stability of the Islamic finance system.
Nonetheless, various Islamic nations adopt multiple models that may seem useful to asset allocation. In numerous jurisdictions including Bahrain, Pakistan, Sudan, and Malaysia hybrid models are incorporated depending on the efficiency of the strategies to the respective financial institutions. In the models, multiple products are provided such as Marine insurance, Motor insurance, and fire insurance. In any period, a Takaful agent can either have exceeding money from the members or an underwriting loss (Kader, Abdul, Mike, and Philip Hardwick 170). Entirely different from this, the contribution fund also experiences gains or losses. However, Islam insurance faces several misconceptions among the Muslim faithful. Firstly, Allah’s will on matters related to the destiny of a person. Therefore, insurance schemes are deliberate efforts formed against the teachings of the Quran. Secondly, traditional insurance is banned for all Muslims because it accumulates interests, which is against the Shariah law. Lastly, insurance is associated with gambling hence outlawed in Islam. The misconceptions have affected the adoption of insurance thereby to some extent reduced asset allocation efficiency in Islamic banking and finance.
Islamic banking and finance incorporate the portfolio management strategy with the motive of managing and monitoring risks, particularly in credit cards. Financial institutions adopt portfolio management to accumulate higher returns with lower risks. Essentially, multiple Islamic institutions adopt the leverage strategy which has the potential to increase profits while at the same time increase risks in investments. Ideally, traders in a market-oriented economy will either purchase option contracts or seek loans in financial institutions. Additionally, Islamic institutions encompass the expectation strategies that entail transferring short-term and long-term bonds based on the anticipation of a given period. Since the value of long-term bonds increase their value with time most investors prefer to hold these bonds that would, in turn, increase the portfolio value hence increasing the returns (Akhtar, Khizer Shama 40). Lastly, the financial institutions use the yield spread strategies to establish the difference between investments and their rates of return. The yield spread compares two financial commodities with the aim of minimizing or curbing trade-in risks. Therefore, investors use risk premium in investing different kinds of investments with the goal of leveraging profit and losses in the market.
Islamic banks adoption of monetary policy implementation on dual financial system affects the stakeholders at the early stages of development. Similarly, the transmission channels experience several challenges; for instance, Islamic financial institutions are underdeveloped thereby restraining the ability of the corporations to use market-oriented tools to effect policy. Similarly, macroprudential policies play a vital role in predicting systemic risks in financial institutions. Islamic banking and finance institutions encompass structures that cover a wide range of real estate activities, investment companies, and banking. The interconnections expose financial institutions to multiple risks (Kammer et al., 15). For instance, Islamic banks in Southeast Asia increase their exposure through Small and Mid-sized Enterprises throughout other sectors primarily through leasing contracts. Diversification of vulnerability across different sectors contributes to financial stability. Several Islamic institutions do not necessarily add value to their respective domestic market but have transferred their services across international borders thereby posing a risk at the local and regional level. The significance of IFIs and the gaps within the banking and finance sector calls for macroprudential oversight such that financial experts tailor the macroprudential loops and instruments appropriately. The instrumental framework ensures that macroprudential policy is amended and implemented according to the Shariah governance structures.
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