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Asset-Backed Financing in Western and Islamic Ethical Finance

Islamic ethical finance (IEF) is an alternative financial system which is both universal (i.e. not limited to Muslim-majority countries) and parallel to the existing economic regime. Understanding the opportunities of IEF requires an exploration of the engineering behind asset backed financing as this highlights the differences in the underlying philosophy of IEF in comparison to the conventional financial system.

In a typical financial system, greater risk requires a greater return. An institution or an individual putting up money for a new business will expect more financial compensation the riskier they perceive the venture. The idea behind the ABSs that precipitated the Global Financial Crisis (GFC) of 2008 was one where higher rates of return were retained without the underlying risk, or rather, where the apparent risk was obfuscated. However, ‘asset-backed securities’ (ABSs) as financial instruments in the conventional financing system are based on different principles than those used in IEF. The ‘assets’ that form the basis of a conventional bond come from the repayment of debt, such as student loans or mortgages. In other words, the assets underlying ABSs are income streams from people indebted to financial institutions.These are then packaged into another type of investment to be sold further on. Due to the financial crisis of 2008, the most well known of these are “residential mortgage backed securities,” created by banks which failed to properly screen loan applicants. Normal indicators of credit worthiness were overlooked, putting each individual borrower at a higher risk of defaulting on their payments. This was especially so given the environment of falling housing prices. However, the process of bundling these loans together into a composite bond obscured their underlying risk. [1]

The purposeful nature of this obfuscation is made evident by how these ABSs were further ‘structured’ and packaged into ‘collateralised debt obligations’ (CDOs). This involved splitting the bond into different risk categories where certain bondholders would bear the losses before others. The most senior of these tranches were then marketed as safe investments. The core assumption behind these CDOs was that housing prices would never fall and that banks would continue to receive repayment on the dodgy loans they had made. Ha-Joon Chang’s ‘Economics: The User’s Guide’ provides a clear explanation of this decoupling of rates of return from risk; it made the resulting bonds much more attractive than they would have been otherwise and actually qualified them to be bought by pension funds and other investors with risk-averse mandates. [2]

In contrast, an asset-backed sukuk, or Islamic bond, is engineered according to principles of ethical finance. Asset-backed sukuks involve the transfer of ownership of part of a tangible good or of part of a business. Four broad principles underlying ethical finance are: risk sharing, “symmetrical risk/return distribution each party to the transaction may face”; materiality, “a financial transaction needs to have a ‘material finality’, that is, it is directly or indirectly linked to a real economic transaction”; fairness, “a financial transaction should not lead to the exploitation of any party to the transaction”; and avoidance of unethical industries. [3] Another important principle related to IEF is the prohibition of gharar; “preventable uncertainty”. This prohibits instruments such as “financial derivative instruments, forwarding contracts, and future agreements.”[4] While this may seem like an undue restriction, derivative instruments such as credit default swaps were used as a kind of insurance against CDOs defaulting, further distorting the actual risk of these investments. The word gharar is of Arabic origin and the three-consonant root of the word gh-r-r can also form the word ghuroor, which means deception. The asset-backed sukuk therefore resembles more of an equity-like structure. When investments like this are engineered along the ethical principles inherent in IEF, the sharing of risk and returns encourages a longer-term outlook for investment and business decisions. A laissez-faire attitude towards regulation over the past thirty years has been the direct cause for the increase of investments and finance focusing on short-term gain. This has been a major reason behind the structural instability in the global financial system over the past thirty years. [5] Chang points out that when conscientious governments created a more stable environment for investment between World War II and the mid-70s, no countries experienced a banking crisis of the likes which are regularly occurring now.

Examining the differences in the meaning of ‘asset-backed’ in conventional financing and in IEF highlights their different approaches to oversight. In conventional financing, relationship with oversight is characterised by battling with regulators, trying to deceive them or colluding with them to run around the spirit of the law. In IEF, judicious principles are followed from the initial stages of engineering and onwards throughout marketing and sales. The universality of Islamic finance comes from its principles that emphasise social development, long-term planning and an understanding that supernormal returns leads to systemic instability.

Despite the potential universal appeal of IEF, there remain barriers to its widespread implementation. These include a lack of worldwide legal and accounting standards and conservative regulatory regimes, as well as the absence of local support in Muslim countries. [6] These issues have to be addressed before finance based on Islamic ethical principles goes “beyond low yielding credits to cover the entire risk-return spectrum.” [7]

Rather than moving wholesale to an entirely different system of finance, there is now an emerging space for parallel systems. Countries with a strong rule of law possess the potential for “rules governing both conventional and Islamic banks, capital markets and insurance.” [8] Under this system questions of finance would go beyond merely the superficial rates of return on investment and would instead help investors understand how their individual investments can increase the overall economic welfare of society.

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[1] Chang, Ha-Joon. Economics: The User’s Guide, A Pelican Introduction, (2014)

[2] Chang 2014

[3] El – Hawary et al. “Diversity in the Regulation of Islamic Financial Institutions”, The Quarterly Review of Economics and Finance (2007)

[4] Jobst, AA. “The Economics of Islamic Finance and Securitization”, IMF Working Paper (2007)

[5] Chang 2014

[6] Jobst 2007

[7] Jobst 2007

[8] Mara, AD. “Saudi Arabia: The Duality of the Legal System and the Challenge of Adapting Law to Market Economies”, Arab Law Quarterly (2004)

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