Regulation & Risk

Regulatory Framework For Islamic Finance

 

Generally, the objective of a regulatory framework within which a financial system operates is established for the purpose of protecting the system from abuses that may threaten the stability of financial relations. In doing so, attention is paid to the risk of financial transactions.

 

The risk of any transaction can be managed in three ways. Risk can be transferred, shifted or shared. Depositors transfer their risk to a bank that then transfers it to borrowers. In this case the bank is an intermediary. Risk can be shifted in two different ways. A person shifts the risk of life or health to an insurance company with full knowledge and acquiescence of the latter that accepts the shifted risk for a fee.

Risk of a transaction between two parties can be shifted to a third party without the knowledge or consent of the latter, through asset securitisation and packaging into leveraged securities. This is what happened in the aftermath of the 2008 crisis when bailouts shifted the burden of losses mostly to taxpayers.  Historical experience shows that at times risk transfer regime can and does switch into risk shifting with huge costs to innocent bystanders.

As Tan Sri Andrew Sheng has said, gains are privatised and losses socialised. With risk sharing all parties to a transaction share the risk according to their ability to carry it; they all have “skin in the game.”

Finally, risk can be shared between two or more parties all sharing according to their ability to bear a portion of the total risk. The foundation of the conventional financial system is the interest bearing debt contract, which creates an asymmetry in risk. In technical terms, the lender shifts risks in a debt contract asymmetrically with a stop loss option. If the borrower defaults, all risks are borne by the borrower, including bankruptcy. Furthermore, in a widespread bank failure, the state bears the risks. But on the upside, the banks enjoy the interest return. The tax benefits are also obvious, since both interest and provisions on bad debt are tax deductible.

The result is that the whole economy and financial system has become highly leveraged, with high debt and low equity risk is completely shifted to the system as a whole, whereas the real sector bears all risks if the financial system collapses.

REGULATION AND RISK TRANSFER REGIME

Conventional finance is organised as a risk transfer regime. Its regulatory framework is geared toward protecting depositors and creditors. Regulatory elements are designed to minimise risk to loans advanced regardless of the purposes of project for which the amount is borrowed.

Regulation’s objective is to ensure that banks do not abuse the system by taking risks that would threaten the integrity of the deposit and payment systems. Regulation framework is strengthened by the lender of last resort (LOR) function of the central bank with its deposit insurance to maintain confidence of depositors and creditors should there be a bank failure. To be sure there are workout mechanisms and bankruptcy procedures to help debtors but these operate outside of the regulatory framework.

Research in the last few years has discovered a link between fractional reserve banking, LOR function, credit expansion, debt bubbles, leverage and financial crises. Many now recognise limits to the efficiency of risk transfer regime mainly because of moral hazard and the ability of the regime to morph into risk shifting.

ISLAMIC FINANCE

Based on the Qur’an and Sunnah, the essence and strength of Islamic finance is its mission of facilitating the sharing of risk and prosperity in the society (Kuala Lumpur Declaration. 20th September, 2012; available from ISRA internet site).

The significant potential contribution of risk sharing finance to increased prosperity has been a subject Nobel Laureate Robert Shiller has been advocating since the early 1990s. The major difference between risk-sharing finance and Islamic finance is that the latter is embedded in a network of rules (institutional scaffolding) that allows efficient and just distribution of financial resources of the economy.

These rules are prescribed in the Qur’an and in the Sunnah. They include, inter alia, sanctity of human dignity; sanctity of property sanctity of contracts; trust; cooperation; rules governing consumption, saving, investment; rules of governance; rules governing market behavior of participant.

JUDGING THE SUCCESS OF ISLAMIC FINANCE: THE LITMUS TEST

As a risk-sharing financial system, Islamic finance proper would display the following major characteristics, among others:

  1. it would forge a close (one—to—one) relationship between financial and real assets;
  2. it would facilitate financial inclusion by providing ways and means of access to finance to all members of society. This would provide an opportunity to all members of the society to share in prosperity and to hold financial instruments (personal and particular) risks;
  3. it would result in stable and antifragile (Nicholas Naseem Taleb in his book: Antifragility) financial system highly resilient to shocks; and
  4. it would empower all stakeholders to have effective voice and vote in the governance of the financial sector.

The overall significance of Islamic finance operation, the litmus test, is how effective its role would be in alleviating poverty through financial inclusion and sharing of the fruits of prosperity resulting from risk-sharing finance.

COMPLEXITIES OF REGULATING A DEBT-BASED FINANCIAL SYSTEM

A compelling case can be made that regulation of a risk sharing financial system without fractional reserve banking and no interest rate mechanism operating within the confines of an institutional framework governed by rules, mentioned above, would be less complicated and more effective than a risk-transfer and debt-dominated financial system. Arguably, the regulatory framework for the latter is, by necessity, complex.

Regulation has to protect depositors, creditors and the public at large in a system replete with moral hazards and informational problems of fractional reserve banking, credit-creation ability of the banking system, interest rate based system capable of creating debt bubbles, speculative activities incentivised by (cheap) credit expansion through leverage.

This complexity is enhanced by the ability of politically powerful banks and creditors to game regulation (regulatory capture and arbitrage) thus undermining the functioning of an oversight system whose ultimate objective is protection of the financial system’s integrity and the interests of the public at large.

By contrast, regulation of the former system would be much less complicated because the framework would have to focus on the balance sheet of financial Institution whose only function would be to serve as financial intermediaries or risk sharers with their own share of “skin in the game” (Taleb).

Further complexity stems from the fact that a major lesson learned from the experience of 2008 crisis is the need for greater attention and focus of regulation on asset markets and potential systematic risk of banking operations. These additional considerations make the job of designing and implementing such a comprehensive regulatory/supervisory framework highly challenging.

REGULATORY FRAMEWORK OF ISLAMIC FINANCE

Because of the risk-sharing nature of Islamic finance operating within rules prescribed by the Qur’an and Sunnah, without an interest mechanism (replaced by the rate of return to the real sector of the economy), no fractional reserve and no deposit guarantees, regulation has to focus only on the balance sheet of financial intermediaries. The key regulatory targets become the degree of proximity of financial and real sector transactions and the coordination of asset/ liability structure of balance sheets of financial intermediaries related to the following three elements: asset/liability maturity, risk and values. By definition, this regulatory Framework would be substantially different from that in a risk transfer system. Specifically, regulation targets the following:

  1. full transparency of each item of the balance sheet;
  2. each money of transactions on the balance sheet must have corresponding money of real assets such that rates of returns, dividends and other payoffs to stakeholders reflect close relationship with the rates of return to the real sector of the economy;
  3. balance sheets must demonstrate transparently a coordinated asset/liability maturity structure;
  4. balance sheets must demonstrate transparently a coordinated asset/liability risk-matching structure so that no item on the asset side is more risky than corresponding item on the liability side;
  5. balance sheets must demonstrate transparently coordinated matching of asset/liability value structure such that price changes that lead to value changes on the asset side must also be mapped automatically onto the liability side; and

6. governance structure of financial intermediaries must reflect empowerment of voice and vote of all stakeholders

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