How Can Islamic Finance Move Forward?

By Prof Abbas Mirakhor, First Holder of INCEIF Chair of Islamic Finance.

The most important lesson Islamic finance can learn from financial crisis of recent years is to reduce over-reliance on debt-based instruments and to introduce more risk-sharing instruments. This is not to say that instruments such as murabahah are not Islamic. They are. However, we should not be overly reliant on it.

The derivatives world is explained by the theory of spanning, where one basic instrument can be spanned into infinite numbers of instrument, like a peacock’s tail that has one base but can expand widely. Robert Shiller, a professor of economics at Yale University, is an advocate of risk-sharing instruments. He argues risk-sharing has much to contribute to the growth of economies and to social solidarity. One practical way of implementing risk sharing in the economy is to start with the use of participation instruments to finance government developmental projects: agricultural development, infrastructure development and the like. The government can issue participation securities in infrastructural projects such as highway construction projects. This way the development expenditure will be funded by the people of the country. Asian countries, well known for their high savings ratio, represent fertile grounds to explore this option.

One impediment to risk sharing that always comes to mind is the element of trust often missing or weak in many societies. For risk-sharing instruments to work, the partners in the project must be trustworthy, which unfortunately is not always the case in today’s world. How should one manage this problem?

The answer relates to the issue highlighted above – regulation. Policy can create strong regulation and supervision as credible institutions with potential to substitute for weak trust. In a development project, for example, good project management aspects must be introduced from selecting qualified contractors to management of collection in the project. This introduces a disciplined form of financial management for the government. Instead of issuing a debt-based bond to raise funding, participation securities can be issued to raise funds for specific projects. The return to the investors is dependent upon the performance of the project. The cash flows in the project are ring fenced and used to pay the investors.

This instrument cannot, however, be offered to the commercial banking large customers. Usually such debt instruments are issued in large denominations where only large financial institutions and high-net worth individuals can purchase them.

Participatory instruments must be small-denominated market-based instruments, exchange-listed securities. This is important to provide liquidity for the small investors. If an investor wants to exit the investment, he can do so by selling his/her certificates to other investors. This process should start with government projects, as it provides a sense of security to the investors. People trust the banking system because the government stands behind it. The same sense of security can be deployed to kick-start this type of risk-sharing instrument.

This approach not only reduces the burden of budget deficit on government books, it also provides an alternative investment instrument for the masses instead of a guaranteed bank saving or risky equity shares. Participation securities provide moderated equity-like return with a reasonable sense of assurance form the government.

Although the suggestion is simple on paper, a number of practical implementation procedures must be put in place to ensure the success of this undertaking. If there is political will to support this instrument, it will provide an ideologically neutral investment instrument for Muslims and non-Muslims alike.