ROLE OF FINANCE AND FINANCIAL MARKETS: STRUCTURE AND MANAGEMENT IN AN ISLAMIC PERSPECTIVE

DR. HUMAYON DAR VICE-PRESIDENT, DAR AL ISTITHMAR, LONDON http://www.daralistithmar.com

LECTURE OBJECTIVES
To introduce the participants to the role of finance and the treatment of financial markets in the literature on Islamic economics and its off-shoot, Islamic banking and finance. The lecture also aims at explaining some important Islamic financial structures, institutions and markets. The primary objective of the lecture remains as discussing the Islamic economic perspective on management, with a particular reference to the emerging Islamic enterprise.

LECTURE OUTCOMES
The participants must have an understanding of the importance, Islamic economics tends to attach to finance and financial markets in building a distinct Islamic economy. The participants must be able to evaluate the achievements of Islamic economics in terms of its influence on the development of different financial structures, institutions and markets all over the world. The participants must be aware of some key issues in management of Islamic enterprises. Finally, they must realise that a distinct Islamic management style is imperative for running of Islamic enterprises in a successful and Islamic way.

REFERENCES
IQBAL, Z. AND MIRAKHOR, A. (2001) Role of Stakeholders in Islamic Financial Institutions Initially published as a World Bank Working Paper, but later published in Islamic Economic Studies (2004?) available from IRTI. LEWIS, M. K. (2005) Islamic Corporate Governance, Review of Islamic Economics, 9(1), May 2005. Available from MIHE DAR, H. A. (2005) Principles of Islamic Management (unpublished) Available from the author

LECTURE PLAN
Divided into four sections (excluding introduction and concluding remarks): Introduction (5 minutes) Role of finance in Islamic economics (5 minutes) Treatment of financial markets in Islamic economics (5 minutes) Islamic financial structures, institutions and markets (20 minutes) Islamic management: an emerging discipline? (20 minutes) Summary and conclusions (5 minutes) Questions and Answers (60 minutes)

INTRODUCTION
Islamic economics gave birth to Islamic banking and finance The practice of Islamic banking and finance requires a distinct Islamic management style The idea of sharing (gaining and losing together) should not be restricted to shareholders, depositors and other clients Rather, it should encompass the whole organisation and its wider stakeholders The notion of corporate governance The doctrine of corporate social responsibility Without managing an Islamic enterprise in an Islamic way, no credible and socially acceptable Islamic structures, institutions and markets possible The need for Islamic management

ROLE OF FINANCE IN ISLAMIC ECONOMICS (1)

Emphasis on the prohibition of interest and the need for alternative modes of financing Mudaraba and Musharaka emerged as alternative to interest Financing as opposed to lending PLS Profit Loss Sharing suggested as an alternative to interest rate mechanism for the conduct of monetary policy (macro context), and a mode for banks to provide finance to businesses (micro context) PLS was perceived as a more just and equitable relationship between a financier and business being financed Other modes of financing, like Murabaha, Ijara etc., are used to provide financing for a real economic activity

ROLE OF FINANCE IN ISLAMIC ECONOMICS (2)

Emphasis on asset-based financing emerged This, along with the prohibition of gambling and excessive risk-taking (Gharar), ensured that Islamic financing was free of unhealthy speculation adding to financial bubbles and bursts Finance, in an Islamic economic framework, plays an important role in fostering economic activity, without contributing to large fluctuations in the performance of the overall economic system This is distinctively different from capitalism wherein interest-based financing may give rise to excessive risk-taking (on part of businesses) in times of low interest rates, and over-exposure to risk (of banks) in times of high interest rates

ROLE OF FINANCE IN ISLAMIC ECONOMICS (3)

In socialism, on the other hand, finance and financing was centrally planned and organised no financial markets In an Islamic economy: Finance (and financial institutions) fosters economic growth through contribution to the real economic activity Financing, as opposed to lending, is not interest-based It is always asset-based There is no concept of lending to businesses

TREATMENT OF FINANCIAL MARKETS IN ISLAMIC ECONOMICS

Financial markets must operate observing Islamic principles of fair trade, information disclosure and transparency, using Sharia-compliant methods and structures In the absence of interest rate mechanism, PLS ensures stability of the overall financial system, and brings equity to the transacting parties Mohsin Khan, Abbas Mirakhor, Wiqar Masood Khan, Nadeem ul Haq, etc. Financial markets play a vital role in fostering economic growth Habib Ahmad Financial markets in an Islamic economy also help the government/central bank implement an Islamic monetary policy Mohsin Khan, Abbas Mirakhor, Wiqar Masood Khan, Nadeem ul Haq, etc.

ISLAMIC FINANCIAL STRUCTURES, INSTITUTIONS AND MARKETS

Structures Contracts and products Institutions Banks Finance houses Insurance companies (Takafol and re-Takafol) Other financial institutions Markets Bahrain UAE Malaysia Qatar Saudi Arabia

ISLAMIC FINANCIAL STRUCTURES (1)

Contracts and products Murabaha, Ijara, Salam, Istisna, Mudaraba, and Musharaka etc. Sukuk Takafol Islamic mortgages Islamic funds Risk management in Islamic structures Benchmarking The role of promises, undertakings and options

ISLAMIC FINANCIAL STRUCTURES (2)

Role of benchmarking in mitigation of uncertainty and, hence, of risk Most Islamic products are priced with reference to an interest-based benchmark, e.g., LIBOR, KIBOR, KLIBOR etc. Interest-based benchmarking allows Islamic banks and financial institutions to manage deviations from the market rates of return The promises, undertakings and options are embedded in Islamic structures to manage risk The most-widely used contract of Murabaha is, in fact, a promise to purchase arrangement AAOIFI calls it an order to purchase Without this promissory arrangement (the clients undertaking to purchase the asset from the bank once it has bought it from the market), Murabaha is not bankable

ISLAMIC FINANCIAL STRUCTURES (3)

In Sukuk al-Ijara, the master Ijara agreement allows issuers to price Sukuk certificates in terms of LIBOR-linked floating rates Investors actually receive a rate of return linked to a market rate of return (LIBOR) The master Ijara agreement is no more than: An undertaking on part of the issuer to sell the underlying asset to the initial owner of the asset for a known price An undertaking on part of the lessee to pay a rental to be determined by the prevailing LIBOR at the time of appraisal of the rent (normally quarterly) We, at Dar Al Istithmar, have developed a technique that allows the issuer of investment certificates to offer a rate of return determined by performance of a chosen index

ISLAMIC FINANCIAL STRUCTURES (4)

Managing moral hazard in share contracts (like Mudaraba) Mudaraba is inherently prone to moral hazard and adverse selection (the agency problem) A fixed-return Mudaraba, or a benchmark-linked Mudaraba, manages the agency problem to make it bankable This allows Islamic banks to charge a fixed return on their Mudaraba-based financing to businesses How may it work? Combining two conditions in a smart way The business is allowed to retain profits beyond an agreed profit level (allowed by all mainstream schools of thought) The bank may receive maximum of a fixed fee and a profit share, whatsoever be greater, if the profit falls short of an agreed level (Hanafis permit it)

Condition 1
Banks profit share

Banks payoff

P0

Realised profit

Condition 2
Banks profit share

Banks payoff

Fixed fee

Agreed profit ratio

P0

Realised profit

Combing Conditions 1 and 2

Banks profit share

Fixed fee

Banks payoff

Agreed profit ratio

P0

Realised profit

ISLAMIC FINANCIAL INSTITUTIONS

Banks retain their financial intermediary role in an Islamic framework; however, they must adhere to their social responsibility Islamic structures like Sukuk are helping in developing Islamic capital markets asset-based finance is at the heart of this movement Takafol companies are meeting insurance needs of Muslim communities by adhering to Islamic principles (of the prohibition of Gharar and gambling) by offering capital protection (effectively if not contractually) to their clients Other institutions, like Liquidity Management Centre, have also started emerging to deepen Islamic capital markets

ISLAMIC FINANCIAL MARKETS

Viable Islamic financial markets in different Islamic countries Bahrain, Malaysia and Dubai fast emerging as dynamic Islamic financial markets Trading in Islamic options to start soon at the newly opened Dubai International Financial Exchange More sophisticated Islamic products and structures, larger Islamic financial institutions (mega Islamic banks), and everexpanding Islamic financial markets

ISLAMIC MANAGEMENT (1)

What do we mean by Islamic management? Islamic management accounting (Malaysian contribution, AAOIFI) Management of Islamic (voluntary) organisations (Rafik Beekun) http://www.islamist.org Business management in Muslim countries Managing an Islamic enterprise Islamic management as a distinct management style Islamic Perspectives on Management and Organisation by Abbas J. Ali, published by Edward Elgar (2005)

ISLAMIC MANAGEMENT (2)

Managing an Islamic enterprise What is an Islamic enterprise? The Islamic firm in Islamic economics The Islamic firm is a nexus of Islamic contracts between owners of factors of production, making them contractually bound to cooperate within an organisation, and working within the legal limits imposed by the Islamic Sharia, to achieve a well-defined objective in terms of production of a good or service. Managing such a firm in an Islamic way is the subject matter of Islamic management

The Islamic firm

Owners of factors of production within an organisation

Unambiguous contracts Objective function Definition of property rights Legal system (Fiqh)

Specification of rights and responsibilities

ISLAMIC MANAGEMENT (3)

Role of contracts in Islamic management Writing unambiguous (Gharar-free) contracts is a first step towards managing an Islamic enterprise Islam recognises that there is no such thing as a complete contract it, therefore, emphasises on unambiguous contracts Unambiguous contracts minimise the occurrence of disputes and conflicts within organisations A variety of contracts like agency (Wakala), profit sharing (Mudaraba), partnership (Musharaka), promise of reward or bonus (Jiala) provide an array of incentives to different parties within an organisation

DERIVING PRINCIPLES OF ISLAMIC MANAGEMENT (1)

PRINCIPLE 1 Managers are required to identify and/or define objective function of the firm to use for delineating consistent strategy for operations. Thus, adopting a mission statement is probably the most important aspect of managing an Islamic enterprise It should differentiate between an Islamic and a conventional business

DERIVING PRINCIPLES OF ISLAMIC MANAGEMENT (2)

Mission statement of GFH Our mission is to remain one of the regional leaders in Islamic banking and participate in the economic, infrastructural and social development programmes of the Gulf Cooperation Council, Middle East and North African countries. Gulf Finance House aims to maximise clients and shareholders value in accordance with the principles of Shariah, contribute towards the global growth of Islamic banking and provide a challenging environment to our employees encouraging innovation and realisation of potential.

DERIVING PRINCIPLES OF ISLAMIC MANAGEMENT (3)

Mission statement of ABC Our mission is to Consistently generate increasing value for our shareholders Specialise in Arab-related activities across the world Invest in international financial institutions that diversify and enhance shareholder value Attract an retain high quality employees by providing rewarding careers The two mission statements clearly differentiate between the two businesses

DERIVING PRINCIPLES OF ISLAMIC MANAGEMENT (4)

PRINCIPLE 2 Clear and unambiguous definition of rights and responsibilities of each group of actors within an organisation is essential for efficient and effective use of resources. It helps in reducing moral hazard and slack in organisations

DERIVING PRINCIPLES OF ISLAMIC MANAGEMENT (5)

PRINCIPLE 3 Devising incentive mechanisms like profit-related remuneration packages and performance-related bonuses, and effective monitoring are important for successful managing. It further helps in minimising the agency problem

DERIVING PRINCIPLES OF ISLAMIC MANAGEMENT (6)

PRINCIPLE 4 Decision-making is a horizontal process in which those with right qualifications are consulted by the leader.

Decision-making
Approval/Ratification

BOARD OF DIRECTORS Owners and their representatives

Recommendations

EXECUTIVE BOARD A team of top management

Recommendations

SHRA BOARD Representatives of workers, supervisors and managers

Consultation

Workers

Supervisors

Managers

DERIVING PRINCIPLES OF ISLAMIC MANAGEMENT (7)

PRINCIPLE 5 Improvement of quality of human resources primarily through persuasion, education and creation of a proper enabling environment within an organisation is fundamental to Islamic management. Islam recognises that there is no such thing as a complete contract it, therefore, emphasises on unambiguous contracts

DERIVING PRINCIPLES OF ISLAMIC MANAGEMENT (8)

PRINCIPLE 6 Improvement of quality of human resources primarily through persuasion, education and creation of a proper enabling environment within an organisation is fundamental to Islamic management.

DERIVING PRINCIPLES OF ISLAMIC MANAGEMENT (8)

PRINCIPLE 6 Improvement of quality of human resources primarily through persuasion, education and creation of a proper enabling environment within an organisation is fundamental to Islamic management. Islam recognises that there is no such thing as a complete contract it, therefore, emphasises on unambiguous contracts

SUMMARY AND CONCLUSIONS

The emergence of Islamic banking and finance requires managing of the Islamic financial firm in accordance with Islamic principles of doing business Although a distinct Islamic management style has yet to emerge, there is a growing awareness of the need for the Islamic way of managing Islamic firms The literature on Islamic economics is sufficiently rich to offer a starting point for developing an Islamic management paradigm A natural starting point is to look into the theory of the Islamic firm to get implications for the development of principles of Islamic management