Chapter 4
Risk in a Turbulent World: Insights from Islamic Finance1
1. INTRODUCTION
Despite the remarkable technological advances that humanity enjoys in our age, financial instabilities have been on the rise since the 1970s. The steady improvement in the stability of the real economy in the past few decades was accompanied by rising frequency and severity of financial crises (IMF 2007, ch. 5; 2009a, ch. 3). “The fact that the total risk of the financial markets has grown in spite of a marked decline in exogenous economic risk to the country is a key symptom of the design flaws within the system,” noted Richard Bookstaber, Senior Policy Adviser to the Financial Stability Oversight Council in the United States (Bookstaber 2007, 5).
Further, recessions that precede banking and financial crises are more costly to the economy and have a longer negative impact than ordinary recessions. It takes on average four years for the economy to recover from a recession accompanied by a banking crisis, but only one year to recover from an ordinary recession (Reinhart and Rogoff 2009). Furthermore, cumulative loss in GDP in case of financial crises on average is 14 percent, compared to 5 percent in absence of crises (IMF 2008, ch. 4).
Islamic finance is characterised by the view that finance needs to be anchored in the real economy, which distinguishes it from conventional finance just as significantly as the well-known prohibition of interest. The basic principles nonetheless are shared with all faiths of divine origin. Islamic finance, in addition, provides a set of legal and ethical rules that, if adopted properly, should greatly contribute to economic stability (Aziz 2010). This article aims to explore the role of risk in economic activities, and how it interacts with financial arrangements, from an Islamic-finance point of view. The article concludes with some recommendations for regulators to promote stability and productivity of the Islamic financial industry.
2. FUNCTIONS OF RISK
Uncertainty is inherent in our universe. At the most basic level of atomic particles, the uncertainty principle of Werner Heisenberg indicates the impossibility of our knowing the exact position and momentum of a particle (e.g., Kumar 2008). With uncertainty comes risk, that is, the likelihood of loss or failure.2 Risk plays a major role in influencing our behavior and decisions in economic and social life in the following four ways:
One example might elaborate these points. For humans, moving on the ground is much safer, naturally, than flying. Yet, due to incentives, learning, and innovation, travel by air has become much safer than travel by car (ETSC 2003, 12). The fact that air travel was a priori more risky led to the surprising result that it is now less risky than travel by cars.
This shows how incentives interact with risk. Learning, innovation, and discipline can reduce the likelihood of failure. In contrast, carelessness and the tendency to gamble can make loss more likely.
3. DEALING WITH RISK
There are in general two approaches for reducing risk:
For some reason, mainstream economics is little concerned with this approach. It is left to engineering and management sciences to figure out how to reduce chances of failure. Instead, economics is mainly concerned with the second approach:
Risk transfer as such does not reduce the likelihood of loss. It simply shifts the impact from one party to another. In theory, the party taking on the risks should be in a position to manage and mitigate the risks taken on (by diversification through pooling them while avoiding risk concentrations) better than the parties transferring the risks. But nothing in the contract by which risk is transferred specifies or even encourages this theoretical objective. Derivatives, in particular, impose no requirement on the risk taker, be it a hedge fund, an insurance company, a commercial bank, or any other institution.
In reality, however, risk transfer would negatively affect incentives in a manner that makes failure more likely. Economists are well aware of this effect, widely recognised as “moral hazard.” Yet, mainstream economics pays little attention to how likelihood of loss changes due to distorted incentives. Instead, probabilities of failure are assumed to be exogenously fixed, and the task at hand is to derive the optimal allocation and price of risk.
Not only does this approach contradict the way real businesses deal with risk, as pointed out above, but, also, by ignoring the influence of incentives on risk, it might very well lead to higher risks and greater losses. Ignoring the feedback effect of incentives on economic variables was one major reason behind the failure of mainstream economics and finance to predict, let alone prevent, the global financial crisis (Al-Suwailem 2012).
The approach taken by Islamic finance towards risk, as we shall see, encompasses both not-for-profit and for-profit arrangements. In the latter domain, precepts of risk require a certain level of responsibility, with sufficient flexibility for various techniques for risk mitigation. This allows Islamic instruments to combine the best of various approaches to risk mitigation, meanwhile avoiding the major pitfalls that lie behind recurrent financial crises.
4. THE FUNDAMENTAL LAW OF RISK
An important regularity concerning risk in economic life has been very well established: the positive relationship between risk and return. The higher the risk of an investment, the higher is its expected return. “The tradeoff between risk and expected return is the most fundamental notion in modern Finance” (Poitras 2010, 44). A 100 percent perfectly hedged investment implies 0 percent return (Francis 1991, 219). Not surprisingly, “nothing ventured, nothing gained” is the first rule in the business game (Bernstein 1996, 256).
This principle implies the following important result.
4.1 Fallacy of Composition
Because risk is inherent in economic activities, it cannot be eliminated from the economy. If all agents wanted to completely avoid risk, the economy simply would come to a halt. No economy can function without risk. This fallacy has an important implication for the conventional means for mitigating risk.
4.2 Risk Concentration
Suppose that, instead of all agents seeking to avoid risk, the majority of them want to do so, and a minority, like Lehman Brothers or the insurance company AIG, are willing to assume this risk. Then risk would become concentrated on this minority. With higher concentration of risks, the overall risk of the system (i.e., systemic risk) becomes higher: A failure of any of these “risk centers” might lead to a cascade of failures, threatening the stability of the entire system.
4.3 Interconnectedness
Concentration of risk creates higher interconnectedness among agents. Agents previously unconnected become now interlinked through these “risk-centres” such as AIG. Furthermore, by shifting the underlying risk to other parties through a contractual obligation, counterparty risk replaces underlying risk. But this does not eliminate the risk, since counterparty risk might be correlated to the risk being hedged, as Max Planck Institute economist Martin Hellwig (1998, 341–342) observes. When too many agents do the same, they necessarily become much more interconnected and interdependent as they become counterparties to each other. Higher correlation can cause the “law of large numbers” to break down and usual hedging arguments to fail (Brock, Hommes, and Wagener 2009).
4.4 Risk and the Global Financial Crisis
The above analysis, to a large extent, has been the case in reality. According to the U.S. Office of Currency Comptroller, five U.S. banks dominate 96 percent of all derivatives trades in the United States (OCC 2011). This has been the case for the past decade. Warren Buffet, in 2003, warned that “large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who, in addition, trade extensively with one another. The troubles of one could quickly infect the others . . . [and] can trigger serious systemic problems” (Buffet 2003, 14). This was particularly the case with AIG.
During the bubble in the run-up to the global financial crisis, AIG had accumulated huge amount of credit risk, such that the U.S. Federal Reserve had to bail it out by injecting cumulatively more than $180 billion (FCIC 2011, xxv). The chairman of the Federal Reserve, Ben Bernanke, justified the bailout in 2008, saying: “The Federal Reserve took this action because it judged that, in the light of prevailing market conditions and the size and composition of AIG’s obligations, a disorderly failure of AIG would have severely threatened global financial stability” (cited in Cassidy 2009, 326).
Interconnectedness was clearly observed prior to the crisis. According to the Turner Review of the U.K. Financial Services Authority, there was “an explosion of claims within the financial system” which has “increased the potential impact of financial system instability on the real economy” (FSA 2009, 18). A key driver of this explosion of intra-system activities came from the growth in derivative markets, notes Andrew Haldane of Bank of England (Haldane and May 2011). With greater intrasystem activities, the financial sector becomes increasingly homogenous. Greater homogeneity might make each bank individually safer, but it makes systemic risk much larger (Haldane and May 2011, 353).
4.5 Self-Defeating Strategy
The case of AIG clearly shows that attempts to shift risk on a large scale end up with greater risks, which substantially defeat the objective of such risk-transfer. Almost all of bond insurers went out of business after guaranteeing billions of dollars’ worth of subprime debt that soured during the financial crisis (Alloway 2012). The “innovative” instruments created by banks and other financial institutions to trade risks ultimately led to the dangers these instruments were ideally designed to avoid. As University of Chicago professor R. Rajan (2010, 146) points out, “their own collective actions precipitated the events they should have feared.” The same was observed in the 1987 stock market crash, which was due largely to derivatives-based “portfolio insurance.” What was supposed to be insurance created the very losses it was meant to avoid (Patterson 2010, 61).
4.6 Toxic Assets
Concentration of risk can be most clearly observed in collateralised debt obligations (CDOs). CDOs structure a pool of (for example) home mortgages or loans into tranches, whereby the top tranche is the least affected by defaults, and thus receives a very high (e.g., AAA) credit rating. But this can be done only by concentrating risk on the lowest tranche (junior or “equity”), usually described as “toxic waste” or “nuclear waste” (Partnoy 2003, 386; Morris 2008, 41). The “toxicity” of these tranches, known in advance to be highly risky, was the cost of producing AAA tranches; that is, risk cannot be eliminated but is only shifted from one place to another. But the distribution of risk had changed. Prior to tranching, risk was independently diversified. Through tranching, however, default risk became highly interlinked in order to produce apparently safe and “risk-free” tranches (see Krahnen and Wilde 2006).
4.7 Risk Appetite
Shifting economic risk onto other parties will result in the willingness of the hedged party to take additional risks. The reason is simple: Economic agents (individuals, firms, etc.) in a competitive market are seeking to improve returns. By reducing risk, their capacity to take on additional risks, for the same level of capital, rises. Since risk and returns are positively correlated to generate additional returns, the agent would therefore take on additional risks. The more an agent is able to hedge risks, the more risk the agent becomes willing to take in order to make more returns (Patterson 2010, 97).
Economists W. A. Brock, C. H. Hommes, and F. O. Wagener (2009) argue that, in the presence of hedging instruments, traders will be able to take bigger positions on risky assets because they can hedge away more risk. As more traders follow the same strategy in order to improve their returns, the market becomes exposed to overshooting, and hence market volatility increases. When these bigger positions are financed by debt, higher leverage will amplify risks. The authors conclude that adding more derivatives may destabilise markets, increase volatility, and at the same time decrease welfare.
When the two types of risk (the one hedged, and the one taken) are of a similar nature, we end up with a positive feedback loop: More hedging leads to more risk-taking. The result is higher, not lower, risks. This was clear during the global financial crisis. Banks provided home mortgage finance to customers, and then they purchased credit default swaps (CDSs) on these loans. CDSs work similarly, but not identically, to an insurance device, whereby lenders can shift risk of default to the seller of the CDS. By shifting the risks of these loans, lenders were able to lend even more as they had freed up their capital. As home mortgages expanded, house prices went up. As house prices went up, CDSs became less costly as the perceived risk of default became smaller. With CDSs perceived as safer to their sellers and more affordable to buyers, more mortgage lending was advanced to more risky people, hence pushing house prices higher, feeding another round of the loop. The positive feedback loop created a bubble in housing that ultimately had to explode. CDSs were a major factor that fueled the bubble (FCIC 2011, xxiv).
Credit default swaps, however, differ from traditional insurance in that buyers of CDSs need not have any interest in the referenced loan. In this case, the seller and the buyer are simply betting on whether a certain borrower will default or not. These are called “naked” CDSs. According to the superintendent of the New York Department of Insurance and quoted by Bloomberg news on 2 March 2009, about 80 percent of outstanding CDSs are naked. As the majority of derivatives are side-bets, they act as an amplification mechanism of risk (Das 2009; FCIC 2011, xxiv): Instead of risk being confined to the two parties of the loan, it is now replicated several times across the financial market. This shows that risk-transfer instruments that are disconnected from the real economy are liable to create more risk rather than contributing to its mitigation.
4.8 Swings in Attitudes towards Risk
Conventional banking has been described as “boring banking” (e.g., Stiglitz 2010, 81). Simply to lend money and to wait to collect more money offers no excitement and imposes minimal challenges. To improve returns, especially in a context of low interest rates and “cheap money,” banks were induced to move into more “exciting” and highly risky activities, which were typically speculative and little more than gambling (Dunbar 2011).
But because the shift was not in line with economic fundamentals, banks went from one extreme to the other. The collapse of many banks during the crisis shows how costly this swinging can be. The calls to return to boring banking (e.g., Nocera 2012), would have little appeal to banks, and would be very difficult to implement in practise. What we need is a reasonably “exciting” banking but with sufficiently stable and robust structure. This difficult balance is a distinctive characteristic of Islamic finance.
5. ISLAMIC FINANCE
Principles of Islamic finance revolve around the balanced relationship between risk and return. They establish clearly how risk should be related to returns and ownership. As we shall see, these principles address the challenges arising from complex interactions of risk with economic activities. In addition to prohibition of riba (trading money for money), the three most important precepts in Islamic finance governing risk are outlined in the following sections.
5.1 Prohibition of Excessive Risk-Taking and Gambling
Gambling is strictly prohibited in Islamic finance. It is generally characterised as a zero-sum game with uncertain payoffs. Gharar is the more general form of risky transaction. It is described as risk in which likelihood of loss is greater than or equal to that of gain (Al-Suwailem 2006). All zero-sum games, in which by definition one party’s gain is equal to the counterparty’s loss, are not merely risky, but the risk is unjustified since there is no creation of economic value.
Holding “naked” positions in assets by means of derivatives3 (or by “short selling”), a common form of speculation, is a form of gambling, or maysir. Such activities do not create economic value, and thus belong to the class of zero sum games in economic theory.
5.2 Balance of Rights and Obligations
This principle states that one is entitled to benefits of a certain asset, good, or service, by bearing its physical risk (i.e., risk of damage or loss). Alternatively, being liable for the risk of a particular good or service entitles the agent to its benefits. Entitlement to benefits reflects ownership, and this requires responsibility for loss or damage. In Arabic, this principle is stated as: “al-kharaj bidhaman.”
This principle imposes a certain degree of symmetry and balance between rights and obligations. Liability cannot be separated from ownership of the related benefits; one cannot (or should not) bear the risk of an object without being entitled to its benefits. Separating the two, therefore, is not acceptable.
5.3 Profits and Liability
The third principle states that profit or return is justified only by ownership of (and liability for) the underlying asset, good, or service. That is, one cannot make profits from trading an asset or a good without being first liable for it as an owner. In Arabic, ribhu ma lam yudhman is forbidden. Again, this principle emphasises real ownership; debt trading cannot be a source of profit or return.
Making profits from pure lending violates this principle. A lender who lends $1,000 is shifting the risk of this amount of money to the borrower. Hence, any return arising from using the money in trade or investment belongs to the one who bears the risk of such transactions (i.e., the borrower). Since the lender is shielded from this liability, he is not entitled to any return on the loan. This would simply be riba. To earn returns, the financier should finance a trade: to buy a good or service, and then sell it to the customer for a deferred price. The deferred price includes the costs to the financier, including cost of capital. Time value is allowed only in trade, but not in loans. In this manner Islamic finance blocks the road towards self-replication of debt, which leads to detachment of finance from real productive activities.
6. FUNCTIONS OF RISK IN ISLAMIC FINANCE
By balancing risks and benefits of goods and services, Islamic rules of risk provide an environment whereby risk is supposed to perform its social functions. As pointed out earlier, exposure to risk provides incentives to minimise these risks through learning and innovation. However, exposure to excessive risk is undesirable because the size of the possible loss is such that, if it eventuates, the consequences are likely to be socially harmful.
Severing risk from ownership of the underlying good or service allows risk to multiply independent of the real economy, as is the case with CDS and derivatives, which can be contracted several times more than the underlying asset.
Severing risk from ownership of the underlying good or service also distorts incentives, leading to the well-known problem of moral hazard, whereby insured parties have the incentive to abuse the insured good for their own benefit at the expense of the insurer. Moral hazard leads to more risk taking, not lower risk. In the presence of moral hazard, markets are “incomplete,” and in this case, risk transfer may in fact increase risk concentration (Krahnen and Wilde 2006).
Commercial insurance shifts risks in respect of a certain good from the owner to the insurance company, in return for a fee. The insurer becomes liable for losses in respect of the good without being entitled to its benefits. This makes rights and obligations unbalanced, which is inconsistent with principles of Shari’ah. This imbalance leads to adverse selection and moral hazard due to insufficient incentives and deficiency in responsibility. Because of moral hazard and adverse selection, the insurance market ceases to be efficient, and “optimality will not be achieved either by the competitive system or by an attempt by the government to simulate a perfectly competitive system,” as Nobel laureate Kenneth Arrow remarks (Arrow 1971, 220). Moral hazard, according to Arrow, is the most important factor explaining the limitations of insurance as a mechanism for risk shifting (1971, 141); under full insurance, “productive activity and risk-bearing can be divorced,” but such system is “bad because it reduces (or distorts) incentives” for risky enterprises (138, 143). Another aspect of the problem of moral hazard in insurance is that the insurer is, in a sense, speculating that the insured loss will not occur. The insured thus faces the moral hazard of the insurer finding some specious excuse in order to avoid paying a valid claim.
One alternative to commercial insurance is takaful, or mutual cooperative insurance, which in principle replaces commercial (i.e., for-profit arrangements), by not-for-profit alternatives. Instead of replacing ownership with counterparty risk as in commercial insurance, members of takaful pool their risks that are to be insured and make contributions to the risk pool so that valid claims may be paid. The risk pool and the assets financed by its funds belong to the members; hence the moral-hazard problems of commercial insurance are largely mitigated.4
7. RISK EXCHANGE IN ISLAMIC FINANCE
Precepts of risk in Islamic finance do not imply that risk cannot be managed. While for-profit risk transfer is not in principle permitted, risk exchange is acceptable as an inseparable part of a real transaction. Unlike conventional risk-transfer (mainly through derivatives) that involves zero-sum transactions, risk exchange is achieved through mutually beneficial transactions. In this manner Islamic instruments allow for managing risk without falling into zero-sum activities.
Integrating risk with ownership of the underlying good or service provides a set of incentives to manage the risk appropriately and, subsequently, to allocate resources productively. Since Islamic instruments in general involve real exchange of goods or services, as one kind of risk is shifted to one party, a different kind of risk is being taken up by the hedged party. The same gain-from-trade therefore applies to risk exchange in this case. The reason is that, contractually, risk is integrated with ownership of goods and services, and thus, trade of these implies trade of associated risks. Just as trade promotes specialisation and therefore productivity with respect to traded goods or services, exchange of associated risks should achieve the same objectives with respect to risk.
In this manner, risk exchange is unlikely to lead to the destabilizing effects resulting from derivatives. The reason is that as one form of risk is shifted, a different form of risk is assumed. Further, risk exchange would restrict the positive feedback of the kind observed during the credit bubble that ended in the global financial crisis. Furthermore, since risk exchange is contractually in tandem with real economic activities, this greatly limits concentration of risk that might arise from instruments like CDSs. Integration of risk and real ownership of the related benefit imposes specialisation in risk taking, and this promotes diversification of risk rather than its concentration. The real economy, by nature, is diversified. Given that risk in Islamic finance is integrated with trade and economic activities, this means that risk becomes diversified as well.
As the studies of the IMF (2007, 2009a) and of Reinhart and Rogoff (2009) have shown, risks of the real economy have been much lower than the financial sector. Hence, integrating finance with the real economy results in lower overall risks. Accordingly, technological advances in the real economy could greatly help reduce risks in the financial sector provided that the latter remains anchored in the real economy.
Because profits cannot be made in Islamic finance without assuming ownership risks of the underlying good or service, there is an upper bound on risk-shifting to other agents, and thus to interconnectedness (risk correlations) among these agents. Furthermore, the restrictions on debt (prohibition of riba and debt-trading) encourage greater ownership and higher levels of equity. Equity and equity-type instruments play a vital role in the economy, as discussed later.
From an Islamic finance point of view, the swing from “boring banking” to “exotic derivatives” reflects the imbalance between risk and return. By integrating finance with real economic activities, Islamic finance strikes a balance between risks and returns: banks and financial institutions are able to improve returns and satisfy preference for venturing without being involved in speculative bubbles and wealth-destroying activities.
Furthermore, by integrating risk with real economic activities, both dimensions of risk, likelihood of loss and magnitude of loss, can be substantially reduced. Only after having sufficient incentives for learning and discipline could diversification be of added value. Otherwise, the false sense of security arising from shifting risk to others might deteriorate incentives, leading ultimately to higher, not lower, risks, as discussed earlier.
Overall, an effective strategy to contain and control risk is to have it integrated and embedded within real activities. In this manner, risk becomes naturally controlled by the real economy. Meanwhile this would generate sufficient net wealth or equity in order to compensate for such risks. This strategy therefore helps to achieve the two objectives at once: creating wealth and minimizing risk.
8. REGULATORY IMPLICATIONS
The most important lesson of the global financial crisis, and most previous financial crises, is that pure self-interest in profit-seeking markets is likely to result in a devastating impact on the economy at large. In contrast to the assumptions behind mainstream neoclassical economics, it needs to be recognised that self-interest alone cannot produce the common good for all. Externalities and endogenous instability prove the need for proper coordination and cooperation to maintain stability without jeopardizing productivity.
Regulation alone cannot achieve these objectives. Without ethical and moral commitment, any set of legal or regulatory requirements can be evaded or circumvented. Any legal system is only very partially effective without ethics and morality on the part of individuals and decision makers. The Financial Crisis Inquiry Report, prepared by the U.S. Congress in 2011 to investigate the causes of the crisis, concludes that, “there was a systemic breakdown of accountability and ethics” (FCIC 2011, xxii). Ethics must be an integral part of all regulations, particularly those that pertain to the financial sector.
8.1 Stability is a Collective Endeavour
Regulations aim to achieve social objectives that serve the interest of all members of the society. In the case of financial regulations, the most important of these objectives is economic stability. As many writers have observed, stability is a public good (e.g., IMF 2009b, xxii): It requires the collective efforts of economic agents to be achieved. Attempts to improve individual returns at the expense of the society will end up in losses to all. This is most clearly conveyed in the saying of Prophet Mohammad, peace be upon him:
The example of those abiding by Allah’s order in comparison to those who violate them is like the example of those persons who drew lots for their seats in a boat. Some of them got seats in the upper part, and the others in the lower. When the latter needed water, they had to go up to bring water (and that troubled the others), so they said, ‘Let us make a hole in our share of the ship (and get water) saving those who are above us from troubling them.’ So, if the people in the upper part left the others do what they had suggested, all the people of the ship would be demolished, but if they prevented them, both parties would be safe.
Sahih al-Bukhari (no. 673)
A single person might easily cause the ship to sink, but to navigate the ship safely to the shore requires a team of fully coordinated sailors. Stability will be undervalued by private institutions, notes the IMF (2009b) report, and regulations are needed to internalise the costs of instability.
8.2 Finance Should Not Be a Zero-Sum Game
Banks need to internalise social responsibility and not to focus on purely material self-interest. But this should not be only rhetoric. As the saying goes, “the devil is in the details.” Hence, to internalise social responsibility, finance must be contractually integrated with real, productive, activities. Chairman of the Financial Stability Board, Mark Carney, in an interview, insists that banks “must be forced to serve the real economy” (Masters 2012). Severing finance from the real economy not only defeats the function of finance as a means to achieve economic prosperity, but also makes finance necessarily a zero-sum game.
The financial sector can create net wealth by channeling resources to productive and socially desirable activities in the real economy, and by permitting the sharing of risks to facilitate enterprise within the real economy. While it may appear that wealth is being created within the financial sector, if there is no counterpart within the real economy, this wealth proves to be spurious, as gains are recognised while losses (such as asset impairments) remain concealed until after bubbles have burst.
This implies that, for Islamic banks, products designed to end up in pure financing (like organised tawarruq and einah), using redundant commodities that add no economic value, should be greatly restricted. These instruments decouple finance from productive activities. Further, regulators should provide incentives for financial institutions to better integrate financing with real activities, without jeopardizing the soundness and safety of these institutions.
8.3 Over-Aversion to Risk Makes It More Likely
Regulators used to insist on highly rated or highly “safe” investments for banks or other regulated financial institutions. This might make these banks individually safer. But, at the macro level, this might lead to risk concentration, as we have seen earlier. These risks will simply move from the regulated institutions to unregulated ones. The result is concentration of risk without supervision or transparency. The system therefore becomes more risky and fragile, without regulators knowing about it.
To prevent this kind of regulatory arbitrage, and to upgrade “micro-prudential” policy to “macroprudential” perspective, regulators should place more emphasis on proper measures and procedures to be used by banks and regulated financial institutions, rather than solely focusing on the credit rating of the customer or investee. Furthermore, financial institutions of various segments should participate in a kind of mutual insurance to contain risks they jointly face. By applying this requirement to all financial institutions, regulated or not, incentives for regulatory arbitrage would be greatly reduced.
8.4 Leverage Is Dangerous
In the aftermath of the collapse of the hedge fund Long Term Capital Management (LTCM) in 1998, President George W. Bush of the United States formed the President’s Working Group on Financial Markets to examine the causes of the collapse and provide recommendations (WGFM 1999). In the cover letter, the report states:
The principal policy issue arising out of the events surrounding the near collapse of LTCM is how to constrain excessive leverage. By increasing the chance that problems at one financial institution could be transmitted to other institutions, excessive leverage can increase the likelihood of a general breakdown in the functioning of financial markets. This issue is not limited to hedge funds; other financial institutions are often larger and more highly leveraged than most hedge funds.
Leverage can be reduced by encouraging equity and equity-like instruments. Equity acts as an economic shock absorber, and successfully works as a circuit breaker in case of financial panics. Credit linkages can easily spread the shock and lead to contagions. Equity helps to absorb the shock and to arrest the contagion in its early phases. Collectively, the wealth of the society comes down to its total equity; claims against other agents cancel each other out. The higher the level of equity, therefore, the more net wealth the society has.
The perception that “equity is more expensive” is largely misplaced. It has been generally acknowledged in the wake of studies published by economists Modigliani and Miller (1958, 1963), that equity is more expensive than debt only when the market is distorted by factors such as more favourable tax treatment of debt. More recently, Stanford University professor of finance Anat Admati and her colleagues refute the claims that “equity is expensive” and that high capital requirements would affect credit markets adversely. Admati and her co-authors (2011) have called the arguments advanced to support the proposition that equity is more expensive than debt “fallacious, irrelevant, or very weak.” Further, they point out that policies which subsidise debt and indirectly penalise equity, through taxes and implicit guarantees, are distortive. Setting equity capital requirements significantly higher than the levels currently proposed, they suggest, would entail large social benefits and minimal, if any, social costs.
Regulators are aware of the importance of equity, and accordingly, the minimum capital levels set out in Basel III are significantly higher than those in Basel II. In addition, there is more insistence on the loss absorbency of components of regulatory capital.5
Since risk sharing is considered to be highly desirable in Islamic finance, regulators should allow for profit-and-loss-sharing instruments on both sides of the balance sheet of Islamic banks, but with proper systems and procedures in place. This might require a kind of separation between deposit-taking and investment functions, as in “narrow banks” (Kay 2009) and “limited-purpose banking” (Chamley and Kotlikoff 2009).
Instead of credit-worthiness rating, profit sharing requires fiduciary-capacity and business-worthiness rating. With such procedures properly in place, profit sharing should improve both stability and profitability of Islamic financial institutions. To encourage equity-like instruments, the bias towards debt financing in laws and regulations must be substantially reduced, if not totally eliminated (FAD 2009).
9. CONCLUSION
Risk does not disappear by a mere transfer from one party to another. While diversification and related techniques can greatly mitigate the impact of risk, risk as such (i.e., likelihood of failure), can be reduced only by learning and technological advancement that make safety and success substantially more likely. But this requires a proper set of incentives, which in turn requires exposure to these risks. Exposure to ownership risk induces incentives for learning and innovation that would make everyone better off. Risk trading through gambling-like instruments, in contrast, will make the system more risky and make large-scale losses more possible. They defeat the very purpose they are created for.
Islamic finance provides a framework for balancing the relationship between risk and returns. While the framework is conceptually appealing, it requires careful and proper implementation to be practically relevant. At a time when the world is looking for a paradigm change in the global economy, as Jean-Claude Trichet (2009), then president of the European Central Bank, remarks, the Islamic financial industry bears a great responsibility to contribute to the new paradigm and the sought-after global financial stability.
NOTES
1. The views expressed in this chapter are those of the author, and do not necessarily reflect the position of the Islamic Development Bank. Special thanks to Rifaat Ahmed Abdel Karim and Simon Archer for their helpful and constructive comments. All infelicities are the responsibility of the author.
2. This likelihood need not be quantifiable or follow a well-defined probability distribution.
3. For example, a “naked” put option is a put on an asset that the buyer of the put does not hold, while a “naked” call is a call on an asset that the seller of the call does not hold.
4. For practical issues related to takaful, see Archer, Karim, and Nienhaus (2009).
5. See Archer and Karim (2012).
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