Islamic banking continues to be a growing sector in the global financial marketplace, with US$1.4 trillion in Islamic financial products traded in 2013, and an expected trading volume of more than $2 trillion in 2014. However, Islamic banking must operate within the constraints of Sharī`ah law — under its purest interpretation, all risks, profits, and losses must be shared equitably among counterparties.
Some financial institutions view Islamic law’s restrictions as a competitive disadvantage, preventing them from offering interest-bearing instruments or engaging in speculative practices. Financial institutions attempting to cope with this disadvantage have led to an ongoing debate over the form versus the substance of products that claim compliance.
Volker Nienhaus, Islamic banking scholar and visiting professor at Henley Business School at the University of Reading, maintains that Islamic banks can turn their competitive disadvantage into a distinctly positive one. Rather than attempt to mimic the instruments of conventional finance using complex contractual arrangements that render them compliant with Islamic law, as is the current practice, Islamic banks should align themselves with the true spirit of Sharī`ah by offering profit-sharing or participatory finance products that serve the real economy.
In his paper, “Capacity Building in the Financial Sector: Strategies for Strengthening Financial Institutions” (PDF), Nienhaus notes: “To make conventional instruments Sharī`ah compliant, or to create Sharī`ah-compliant functional equivalents, legal engineers have to construct a formal link to real assets or to the ownership rights of real assets.” Because the resulting underlying contracts are often complex, they are perceived to be more risky to global market players than products offered by non-Islamic banks that need not comply with Sharī`ah.
Nienhaus maintains that Islamic banks should instead offer products whose performance are explicitly linked to the actual performance of real assets, and where upside and downside risks are contractually shared. Therein lies the opportunity for Islamic banks to distinguish themselves among their competitors in a way that is authentically aligned with Sharī`ah, Nienhaus believes.
Nienhaus reports that in a typical Mushārakah contract between a bank and a counterparty seeking funding, the schedule of profit-sharing can be negotiated at the time the contracts are signed. This financing structure provides considerable leeway for both the enterprise and the bank to reach risk-sharing comfort levels. For example, as Nienhaus explains, the enterprise leaders may be able to negotiate, up front, lower profit ratios to be paid to the bank during times when the enterprise performs under expectations. The bank, on the other hand, can negotiate higher ratios of profit payout during periods when enterprise profits exceed expectations.
A concerted move into participatory finance will require that Islamic banks that have focused more on trading securities than the direct funding of enterprises hire more personnel with the requisite skills for industry forecasting and for analyzing the profitability potential of individual nonfinancial firms. As Nienhaus maintains, over the long run, this is all to the good: “Participatory finance will establish a new link between finance and enterprises, and create new avenues for the profitable employment of funds in the real economy.”
In a banking marketplace where complex derivatives and securitization are increasingly crowding out real economy transactions, often with highly disruptive and costly societal consequences, the expansion of participatory finance could have an overall stabilizing effect on the global financial markets and economy.
At the Fifth Annual CFA Institute Middle East Investment Conference, held in Jordan on 9–10 April, 2014, Nienhaus will be giving a presentation on Islamic finance.
This post was contributed by Susan Arterian Chang, director of Capital Institute’s Field Guide to Investing in a Regenerative Economy project, based in Greenwich, CT.
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