Risk sharing in finance: the Islamic finance alternative

300 Pages·2012·1.67 MB·English

by  Askari

Risk Sharing
in Finance
The Islamic Finance Alternative
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Risk Sharing
in Finance
The Islamic Finance Alternative
HOSSEIN ASKARI
ZAMIR IQBAL
NOUREDDINE KRICHNE
ABBAS MIRAKHOR
John Wiley & Sons (Asia) Pte. Ltd.
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Copyright © 2012 John Wiley & Sons (Asia) Pte. Ltd.
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ISBN 978–0–470–82966–0 (Hardback)
ISBN 978–0–470–82960–8 (ePDF)
ISBN 978–0–470–82967–7 (Mobi)
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In the Name of Allah, the All Merciful, the All Benefi cent
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Contents
Preface ix
Acknowledgments xvii
Glossary xix
PART ONE
THE H ISTORY AND CAUSES OF FINANCIAL CRISES
CHAPTER 1
A Brief History of Financial Crises and Proposed Reforms 3
CHAPTER 2
Financialization and the Decoupling–Recoupling Hypotheses 31
PART TWO
RISK SHARING AND THE ISLAMIC PARADIGM
CHAPTER 3
A Brief History of Risk-Sharing Finance 49
CHAPTER 4
Risk Sharing and the Islamic Finance Paradigm 69
CHAPTER 5
Risk Sharing in the Islamic Financial System: The Building Blocks 95
CHAPTER 6
Risk Sharing and Vibrant Capital Markets in Islamic Finance 115
vii
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viii Contents
CHAPTER 7
Portfolio Theory and Asset Pricing 133
CHAPTER 8
Complementary Role of Intermediaries and Markets in
Promoting Risk Sharing 159
PART THREE
MOVING FORWARD
CHAPTER 9
Enhanced Access to Finance, Social Welfare, and Economic
Development under a Risk-Sharing System 181
CHAPTER 10
The Role of Institutions and Governance in Risk Sharing 201
CHAPTER 11
Gaps between the Theory and Practice of Islamic Finance 225
CHAPTER 12
Concluding Remarks 247
References 259
Index 277
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Preface
The fi nancial crisis that erupted in the United States in 2007 and quickly per-
meated many of the advanced industrial countries is undoubtedly the most
serious fi nancial and economic crisis since the Great Depression of the
1930s. Its severity has invoked more debate than the run-of-the-mill fi nancial
crisis that seems to occur about once every 10 or so years; and rather than
calling for minor reforms, some academics, practitioners, and policymakers
have been questioning the fundamental stability of the modern conventional
fi nancial system.
The suggested reasons for this fi nancial crisis have been many:
■ wholesale and foolhardy deregulation;
■ inadequate and failed supervision;
■ unregulated and unsupervised fi nancial institutions;
■ an inadequate level of capital;
■ an extended episode of low interest rates;
■ excessive risk taking;
■ the emergence of a parallel banking sector (the repo market);
■ rapid and uncontrolled fi nancial innovations (derivatives);
■ mark-to-market accounting;
■ the consolidation of the fi nancial sector and the emergence of institutions
that are deemed “too big to fail”;
■ shortcomings of the credit rating agencies and, especially, the confl ict of
interest in their operations;
■ excessive assumption of debt and leveraging;
■ increased international capital mobility; and
■ human greed, fraud, and Ponzi fi nance.
The list is long and could be lengthened even further.
Depending on which of these reasons one considers the culprit(s),
recommendations for reform have also been numerous. As to be expected,
reforms are little more than a “bandaging” of the current fi nancial system:
higher levels of capital; breaking up of fi nancial institutions; re-regulation
to include all fi nancial institutions; measures to limit risk taking and to
increase transparency, and more. But it is diffi cult to see how any of these
ix
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x PREFACE
changes will eliminate the likelihood of future fi nancial crises. Higher capital
requirements, for instance, would reduce bank lending, money creation, and
leveraging, but there is always the chance that bad loans could still wipe out
a bank’s capital. Similarly, limiting the size of fi nancial institutions would
reduce, but not eliminate, systemic risk and the need for bailouts. Increasing
transparency in the packaging, pricing, and settling of derivatives would
afford investors more information on pricing and reduce, but again not elimi-
nate, systemic risk. And on and on.
The conventional banking system is a fractional reserve banking
system that is based predominantly on debt fi nancing and, by its structure,
creates money and encourages leveraging. The embedded risk of such a
system is that money and debt creation, and leveraging, could be excessive.
Safeguards such as deposit guarantee schemes—for instance, the Federal
Deposit Insurance Corporation (FDIC) in the United States—and the classifi -
cation of some banks as “too big to fail” are the implicit government subsidies
that reduce funding costs and create moral hazard, encouraging mispricing
and excessive assumption of risk by fi nancial institutions. The mispricing of
loans and assumption of excessive risk, in turn, threaten the liquidity and sol-
vency of fi nancial institutions. Systemic risks that are inherent in the system,
such as the linkages and the interdependencies of institutions, as well as the
prominence of “too big to fail” institutions, create fi nancial instability and
threaten the entire fi nancial and real economy. To enhance fi nancial stability,
regulators would have to adopt policies and practices that eliminate moral
hazard and excessive debt creation and leveraging.
One way to ensure the stability of the fi nancial system is to eliminate
the type of asset–liability risk that threatens the solvency of all fi nancial
institutions, including commercial banks. This requires commercial banks
to restrict their activities to two: (i) cash safekeeping; and (ii) investing client
money, as in a mutual fund. Banks would accept deposits for safekeeping
only (as, for example, in a system with a 100 percent reserve requirement)
and charge a fee for providing this service and for check-writing privileges.
In their intermediation capacity, banks would identify and analyze invest-
ment opportunities and offer them to clients; they would charge a fee for this
service, much like a traditional investment bank. The bank would not be
assuming any asset–liability risk on its balance sheet; instead, gains or losses
would accrue directly to client investors. However, the bank could at the
same time invest its own equity capital in these and other investment projects,
as could its client investors. In this case, the bank would not be assuming
any asset–liability exposure, just a potential loss of some (but not all) of its
capital, which would not endanger the bank’s solvency.
In other words, in this example of a fi nancial system, there would be no
debt fi nancing by institutions, only equity fi nancing; and there would be no risk
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Preface xi
shifting, only risk sharing. Banks would not create money, as they do under a
fractional reserve system. Financial institutions would be serving their tradi-
tional role as intermediaries between savers and investors but with no debt
on their balance sheets, no leveraging, and no predetermined interest rate
payments as an obligation.
Proposals along these lines are not new. Financial systems in some
such form or other have been practiced throughout recorded history (see
Chapter 3). Recently, such an approach was recommended in the “Chicago
Plan.” This reform plan was formulated in a memorandum written in 1933
by a group of renowned Chicago professors, including Henry Simons, Frank
Knight, Aaron Director, Garfi eld Cox, Lloyd Mints, Henry Schultz, Paul
Douglas, and A. G. Hart, and was forcefully advocated and supported by
the noted Yale University professor Irving Fisher in his book titled 100%
Money. Noting the fundamental monetary cause underlying each of the
severe fi nancial crises in 1837, 1873, 1907, and 1929–34, the Chicago Plan
called for a full monopoly for the government in the issuance of currency
and forbade banks from creating any money or near money by establish-
ing 100 percent reserves against checking deposits. Investment banks would
play the role of broker between savers and borrowers and act as fi nancial
intermediators. Hence, under such a system, the inverted credit pyramid,
highly leveraged fi nancial schemes (such as hedge funds), and monetization
of credit instruments (for example, securitization) are excluded. The credit
multiplier is far smaller and is determined by the savings ratio instead of the
reserves ratio.
As stated by Irving Fisher: “The essence of the 100% plan is to make
money independent of loans; that is to divorce the process of creating and
destroying money from the business of banking. A purely incidental result
would be to make banking safer and more profi table; but by far the most
important result would be the prevention of great booms and depressions
by ending chronic infl ations and defl ations which have ever been the great
economic curse of mankind and which have sprung largely from banking.”
According to Fisher, the creation of money depends on the coincidence of the
double will of borrowers to borrow and of banks to lend. Keynes deplored
this double want coincidence as a source of large swings in the circulating
medium. Why? In times of recession, borrowers are over-indebted and see
narrower profi t prospects, and thus become less willing to borrow; while
banks are saddled with impaired assets and are less willing to lend. Jointly,
they cause a contraction of money and, in turn, an aggravation of the downturn
in the economic cycle. Irving Fisher wrote: “I have come to believe that that
plan is incomparably the best proposal ever offered for speedily and per-
manently solving the problem of depressions; for it would remove the chief
cause of both booms and depressions.”
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xii PREFACE
More recent than the Chicago Plan, Laurence Kotlikoff (2010) has
made a proposal along similar lines, coining it “Limited Purpose Banking
(LPB).” Henry and Kotlikoff, writing in Forbes (2010), said of the Kotlikoff
approach:
Were we really serious about fixing our financial system, there’s
a very simple alternative—Limited Purpose Banking. LPB would
transform all financial intermediaries with limited liability into
mutual fund companies. Under LPB a single regulatory agency—
the “Federal Financial Authority”—would organize the independent
rating, verification, custody and full disclosure of all securities held
by the mutual funds. Voilà, by dint of competition and transparency,
“liar loans,” off-balance sheet gimmickry, and toxic assets would
all disappear. LPB would let the financial sector do only what Main
Street needs it to do—connect lenders to borrowers and savers to
investors. The financial sector’s job is not to take taxpayers to the
casino and collect the winnings.
There are many reasons why reform along this, or similar lines, has not
entered the political and fi nancial mainstream until the recent fi nancial
turmoil. For starters, there is the opposition of the powerful fi nancial sector.
The lobbying of the fi nancial sector against fundamental fi nancial reform
in the United States is well documented and its interest is evident. Starting in the
1970s, the fi nancial sector has gained relative to the real sector, as measured
by its growing share of gross domestic product (GDP), aggregate corporate
profi ts, and salaries and bonuses. The fi nancial sector will not readily give
up activities and instruments that have allowed it to establish such a domi-
nant position and to accumulate such gains.1 When risk transfer is combined
with high leverage, the growth of interest-based debt contracts and their pure
fi nancial derivatives—those with little or no connection to real assets—
outpace the growth of the real sector leaving the liabilities in the economy a
large multiple of real assets needed to validate them. This phenomenon has
been coined “fi nancial decoupling” or “fi nancialization,” whereby fi nance is
no longer anchored to the real sector.
A second popular concern is the “assumed” impact on economic
growth and prosperity if debt fi nancing is signifi cantly reduced or elimi-
nated. Although most observers attribute a signifi cant role to the explosion
of debt and leveraging in bringing about fi nancial crises, at the same time
some argue that the reduction, let alone elimination, of debt fi nancing and
bank money creation would reduce economic growth. This is an empirical
issue that deserves careful estimation—how would growth over the long haul
compare under each regime? And what would be the attendant social benefi ts
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