The Economic Challenge and Crisis
Describe about the Islamic Economics?
The economic challenge and crisis in our times are as distressing and deep as ever thus they cannot be ignored. In his pioneering work Dr Muhammad Umer Chapra’s examines the academic rigor and sophistication that the Islamic countries need to form the strategies that can be within the framework of welfare state, socialism and capitalism. (Khan, 2000) The objective of Shari’ah law is to promote people’s welfare. Many centrally planned economies that were claimed to secure the goals have failed thus the Islamic countries are facing a serious crisis. (Wilson, 2006)
The twin objectives of distributional equity and social justice can be embedded in a market dominated economy and this can be done by the help of the conventional finance theory. As Franco Modigliani and Merton H Miller have explained in the American Economic Review that a physical asset is only worth acquiring when it increases the profit for its owners. But this profit can only increase if yield is exceeding the interest. The twin objectives can be achieved for an Islamic economy when the notion of “risk discount” that can be subtracted from the yield.
This book by Professor Mirakhor et al was written, the credit crisis has led to a major re-evaluation of the major pillars of the modern theory of finance – the efficient market hypothesis and the random walk behavior of asset prices. However, all pointers are still indicating that the problem rests with the management of risk and the way it is transferred or shared. There does not appear to be any fool proof way of transferring risk. Indeed, a lot of private risk seems to have been transferred to the taxpayer. This has led to the adage that modern finance has become a scheme to “monopolise profits and socialize losses”. The Islamic finance is based on legal reductionism, theological and financial reductionism but the bigger picture of the Islamic finance is being prevented. We need a better understanding of the Islamic finance as it should be based on social justice without stopping individual enterprise. Chapra conducted a research on it as the Islamic finance should be based on need fulfillment, equity, stability and growth. The twin objectives can be embedded in the market dominated economy by strongly motivating that the individual renders his own interest along with the interest of the entire society. The political, economic and social institutions along with public finances should be reformed to minimize the unnecessary and wasteful consumption of consumption. According to modern finance Islamic finance have to eliminate Riba to have a more stable banking. As equity based system that does not guarantees value of shocks and deposits to asset positions will keep the value of deposits the same. As Islam believes in time value of money should enable the interest rates to be allowed. The balance between the society, shareholder, environmental interests and employee has to be achieved to obtain conventional accounting.
Social values and ethics are inseparable when it comes to finance and economics. In the last forty years the movement related to the Islamic finance and economics is gaining momentum. (Kenneth, 2002)There are many issues in the nature of the Islamic finance some of them are as follows:-
- Methodology of Islamic economy
- Risk management, transparency and implications of the Islamic financial institutions
- Numerous problems with corporate governance
- Performance evaluation
Objectives of Islamic Law
Conventional finance is thus in a similar dilemma to the Islamic economists. Whilst they realize the utility of the markets, they are forced to see the limitations of markets, both due to market failures in key areas and the infectious impact of greed. The present financial sector is all about non bank financial institutions, banks and financial markets. (Clode, 2002) But all of these types are opaque whether it is risks, asset holdings and returns. In a traditional setup the banks investment portfolio and performance related to the investment is not made public on a daily basis. (El Hawary, 2004) Information related to the assets is made available and that to on an aggregate level at a low frequency. This causes the issue of “asymmetric information”. It is a public policy objective to protect the depositor/investor interests. Greater responsibility and role on the part of the regulators in the banking sector is required because the regulators have access to information. The lack of transparency in these institutions has many pros as well as many cons. The appointed management or the bank shareholders have control on the investment decisions but until and unless the risk profile and interests are aligned with the depositors the issue will exist. These issues give rise to moral hazard and adverse selection. These risks that are being experienced by the Islamic banks are also faced by the investment deposit holders. This causes an overall risk that has implications on the banks. These profit smoothening practices in turn weakens the market discipline as there is a reduction in the informational role of the rate of return. This rate of return plays a vital role in the bank performance and its evaluation. The Islamic banks and conventional banks are different as the natures of risks they take are also quite different. In a conventional bank a role of renting out money is played purely thus the risk that they take is the credit risk that emerges from the worth of the financed property. Other risks like legal risk, contract performance risk and interest rate risk also exist. But the Islamic bank is not a pure financial intermediary as it participates in the business to earn a margin or has some type of profit-loss sharing arrangement. This has many direct risks such as liquidity risk, market risk, operational risks and credit risks. This sharing of the risk and loss between the bank and the account holder can be very beneficial and healthy for the economy. Even stability of the financial sector can be achieved through this. This type of arrangement can absorb the economic shocks in a better way. But there are numerous risks which cannot be covered by the risk management strategies of the normal conventional banks. The emphasis on mitigation has to be devised to mutual sharing of unavoidable risks and also to avoid risks. This can ve achieved by devising ways to measure these risks. These risks have to integrated and analysed to manage them on a systematic level.
A paper written by Sundarajan is about “Risk measurement and Disclosure in Islamic Finance and implications of Profit Sharing investment accounts” which addresses issues related to risk measurement. (Sundarajan, 2002) These issues can be addressed through supervision, proper management and regulation. (Sundarajan V. , 2004)A greater disclosure is needed in treatment and report of the changing profit equalization reserves. These reserves influence the risk that the bank has to take. The profit sharing between the investment account holder and shareholders have been limited and usually the losses are absorbed by the shareholders. (Greuning, 2000)This situation is called “displaced commercial risk” as it is the increased risk that is absorbed by the banks shareholders. (Archer, 2002)They require regulatory incentives by linking the capital relief in case of loss or profit to the actual risk that is being borne by the account holders. (DeLorenzo, 2002)
In case of transparency the Islamic banks need an effective disclosure and constraints such as the human resource have to be solved. Muljawan in his paper “A design of Islamic banking rating system: An integrative approach” suggest that the operational soundness in the Islamic banks can be achieved by attuning the nature of the Islamic banks. (Muljawan, 2006) Some of the aspects where the adjustments will be needed are:-
- Considering profit distribution
- Some risks that are not part of the conventional banking have to be recognized and adjusted
- Along with Shari’ah compliance, Islamic values and norms should be incorporated
The need to develop best practices and mechanisms to protect the interest of the stakeholder is a must. This will go a long way in realizing the economic benefits for the Islamic financial system. (Visser, 2008)Every institution draws its legitimacy and strength from the religious and social acceptance from the society. Thus the Islamic banks should abide by the norms and rules to gain public confidence. Profit sharing and risk sharing have to be promoted to achieve some socially desirable results.
References
Ahmed, H. (2004). Role of Zakat and Awkaf in Poverty Alleviation. IDB (IRTI) , 201-230.
Ahsan, P. S. (2000). Theories of Ownership and Islam: A Case Study of The Islamic Republic of Iran. 9 Rev. of Islamic Economics , 127-143.
Archer, S. a. (2002). Islamic Finance: Innovation and Growth . London : Euro Money Books.
Clode, M. (2002). Regulatory Issues of Islamic Finance. London: Euro Money Books.
DeLorenzo, Y. (2002). “The religious foundation of Islamic finance”. London: Euro Money Books.
El Hawary, D. W. (2004). Regulating Islamic Finanical institutions- The nature if the regulated. Policy research working paper 3227 , 56-79.
Greuning, G. a. (2000). Analyzing Banking risk:A framework for asessing Corporate governance and financial risk management. Washington:DC: The world Bank.
Kenneth, B. (2002). Risk Mangement in Islamic Banks. London : Euro Money Books.
Khan, C. M. (2000). Regulation and supervison of Islamic Banks. Occasional paper 3 , 112-115.
Muljawan, D. (2006). “A design of Islamic banking ratinmg system”. Journal of Banking and Finance , 255-77.
Sundarajan, V. a. (2002). Islamic Financial institutions and products in the global Financial system:key issues in risk management and challenges ahead”. IMF working paper WP/02/192 , 150-166.
Sundarajan, V. (2004). Devevlopment of competitive and innovative Islamic financial products and markets:Key issues & policy implications “. International seminar on challenges facing the islamic financial services industry , 89-96.
Visser, M. P. (2008). . The A to Z of Corporate Social Responsibility:A Complete Reference Guide to Concepts, Codes and Organisations. US: Wiley.
Wilson, A. E. (2006). Islamic Economics: A Short History. US: BRILL.
Wilson, R. (2011). The Islamic Economic Doctrine: A Comparative Study”. International Journal of Islamic and Middle Eastern Finance and Management , 104 – 106.
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