Lecture-5 (Nov 7, 2005)[1]

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ROLE OF FINANCE AND FINANCIAL

MARKETS: STRUCTURE AND MANAGEMENTIN AN ISLAMIC PERSPECTIVE

DR. HUMAYON DAR

VICE-PRESIDENT, DAR AL ISTITHMAR, LONDONhttp://www.daralistithmar.com
http://www.daralistithmar.com/http://www.daralistithmar.com/

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LECTURE OBJECTIVES

To introduce the participants to the role of finance and thetreatment of financial markets in the literature on Islamiceconomics and its off-shoot, Islamic banking and finance.

The lecture also aims at explaining some important Islamic

financial structures, institutions and markets. The primary objective of the lecture remains as discussing

the Islamic economic perspective on management, with aparticular reference to the emerging Islamic enterprise.

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LECTURE OUTCOMES

The participants must have an understanding of theimportance, Islamic economics tends to attach to finance andfinancial markets in building a distinct Islamic economy.

The participants must be able to evaluate the achievements

of Islamic economics in terms of its influence on thedevelopment of different financial structures, institutions andmarkets all over the world.

The participants must be aware of some key issues inmanagement of Islamic enterprises.

Finally, they must realise that a distinct Islamicmanagement style is imperative for running of Islamicenterprises in a successful and Islamic way.

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REFERENCES

IQBAL, Z. AND MIRAKHOR, A. (2001) Role ofStakeholders in Islamic Financial Institutions

Initially published as a World Bank Working Paper, but laterpublished in Islamic Economic Studies (2004?) available

from IRTI.LEWIS, M. K. (2005) Islamic Corporate Governance, Review

of Islamic Economics, 9(1), May 2005.

Available from MIHE

DAR, H. A. (2005) Principles of Islamic Management

(unpublished) Available from the author

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LECTURE PLAN

Divided into four sections (excluding introduction andconcluding remarks):

Introduction (5 minutes)

Role of finance in Islamic economics (5 minutes)

Treatment of financial markets in Islamic economics (5minutes)

Islamic financial structures, institutions and markets (20minutes)

Islamic management: an emerging discipline? (20 minutes)

Summary and conclusions (5 minutes)

Questions and Answers (60 minutes)

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INTRODUCTION

Islamic economics gave birth to Islamic banking and finance

The practice of Islamic banking and finance requires a distinctIslamic management style

The idea of sharing (gaining and losing together) should not

be restricted to shareholders, depositors and other clients Rather, it should encompass the whole organisation and itswider stakeholders

The notion of corporate governance

The doctrine of corporate social responsibility

Without managing an Islamic enterprise in an Islamic way, nocredible and socially acceptable Islamic structures, institutionsand markets possible

The need for Islamic management

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ROLE OF FINANCE IN ISLAMICECONOMICS (1)

Emphasis on the prohibition of interest and the need foralternative modes of financing

Mudaraba and Musharaka emerged as alternative tointerest

Financing as opposed to lending PLS Profit Loss Sharing suggested as an alternative to

interest rate mechanism for the conduct of monetary policy(macro context), and a mode for banks to provide finance tobusinesses (micro context)

PLS was perceived as a more just and equitable relationshipbetween a financier and business being financed

Other modes of financing, like Murabaha, Ijara etc., are usedto provide financing for a real economic activity

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Emphasis on asset-based financing emerged

This, along with the prohibition of gambling and excessiverisk-taking (Gharar), ensured that Islamic financing was freeof unhealthy speculation adding to financial bubbles and

bursts Finance, in an Islamic economic framework, plays an

important role in fostering economic activity, withoutcontributing to large fluctuations in the performance of theoverall economic system

This is distinctively different from capitalism whereininterest-based financing may give rise to excessive risk-taking(on part of businesses) in times of low interest rates, andover-exposure to risk (of banks) in times of high interest rates

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In socialism, on the other hand, finance and financing wascentrally planned and organised no financial markets

In an Islamic economy:

Finance (and financial institutions) fosters economic growth

through contribution to the real economic activity Financing, as opposed to lending, is not interest-based

It is always asset-based

There is no concept of lending to businesses

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TREATMENT OF FINANCIAL MARKETSIN ISLAMIC ECONOMICS

Financial markets must operate observing Islamic principlesof fair trade, information disclosure and transparency, usingSharia-compliant methods and structures

In the absence of interest rate mechanism, PLS ensuresstability of the overall financial system, and brings equity to

the transacting parties Mohsin Khan, Abbas Mirakhor, Wiqar Masood Khan,Nadeem ul Haq, etc.

Financial markets play a vital role in fostering economicgrowth

Habib Ahmad Financial markets in an Islamic economy also help the

government/central bank implement an Islamic monetarypolicy

Mohsin Khan, Abbas Mirakhor, Wiqar Masood Khan,Nadeem ul Haq, etc.

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ISLAMIC FINANCIAL STRUCTURES,INSTITUTIONS AND MARKETS

Structures

Contracts and products

Institutions

Banks

Finance houses Insurance companies (Takafol and re-Takafol)

Other financial institutions

Markets

Bahrain UAE

Malaysia

Qatar

Saudi Arabia

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ISLAMIC FINANCIAL STRUCTURES (1)

Contracts and products

Murabaha, Ijara, Salam, Istisna, Mudaraba, andMusharaka etc.

Sukuk

Takafol Islamic mortgages

Islamic funds

Risk management in Islamic structures

Benchmarking

The role of promises, undertakings and options

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Role of benchmarking in mitigation of uncertainty and, hence,of risk

Most Islamic products are priced with reference to aninterest-based benchmark, e.g., LIBOR, KIBOR, KLIBOR etc.

Interest-based benchmarking allows Islamic banks and

financial institutions to manage deviations from the marketrates of return

The promises, undertakings and options are embedded inIslamic structures to manage risk

The most-widely used contract of Murabaha is, in fact, a

promise to purchase arrangementAAOIFI calls it an order to purchase

Without this promissory arrangement (the clientsundertaking to purchase the asset from the bank once it hasbought it from the market), Murabaha is not bankable

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In Sukuk al-Ijara, the master Ijara agreement allowsissuers to price Sukuk certificates in terms of LIBOR-linkedfloating rates

Investors actually receive a rate of return linked to amarket rate of return (LIBOR)

The master Ijara agreement is no more than:

An undertaking on part of the issuer to sell theunderlying asset to the initial owner of the asset for aknown price

An undertaking on part of the lessee to pay a rental tobe determined by the prevailing LIBOR at the time ofappraisal of the rent (normally quarterly)

We, at Dar Al Istithmar, have developed a technique thatallows the issuer of investment certificates to offer a rate of

return determined by performance of a chosen index

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Managing moral hazard in share contracts (like Mudaraba)

Mudaraba is inherently prone to moral hazard and adverseselection (the agency problem)

A fixed-return Mudaraba, or a benchmark-linkedMudaraba, manages the agency problem to make it bankable

This allows Islamic banks to charge a fixed return on theirMudaraba-based financing to businesses

How may it work?

Combining two conditions in a smart way

The business is allowed to retain profits beyond an

agreed profit level (allowed by all mainstream schools ofthought)

The bank may receive maximum of a fixed fee and aprofit share, whatsoever be greater, if the profit fallsshort of an agreed level (Hanafis permit it)

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Condition 1

Banks profit share

Realised profitP0

Banks payoff

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Condition 2

Banks profit share

Realised profitP0

Banks payoff

Fixed fee

Agreed profit ratio

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Combing Conditions 1 and 2

Banks profit share

Realised profitP0

Banks payoffFixed fee

Agreed profit ratio

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ISLAMIC FINANCIAL INSTITUTIONS

Banks retain their financial intermediary role in an Islamicframework; however, they must adhere to their socialresponsibility

Islamic structures like Sukuk are helping in developing Islamiccapital markets asset-based finance is at the heart of thismovement

Takafol companies are meeting insurance needs of Muslimcommunities by adhering to Islamic principles (of theprohibition of Gharar and gambling) by offering capitalprotection (effectively if not contractually) to their clients

Other institutions, like Liquidity Management Centre, havealso started emerging to deepen Islamic capital markets

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ISLAMIC FINANCIAL MARKETS

Viable Islamic financial markets in different Islamic countries

Bahrain, Malaysia and Dubai fast emerging as dynamicIslamic financial markets

Trading in Islamic options to start soon at the newly opened

Dubai International Financial Exchange More sophisticated Islamic products and structures, larger

Islamic financial institutions (mega Islamic banks), and ever-expanding Islamic financial markets

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ISLAMIC MANAGEMENT (1)

What do we mean by Islamic management?

Islamic management accounting (Malaysian contribution,AAOIFI)

Management of Islamic (voluntary) organisations (Rafik

Beekun)http://www.islamist.org Business management in Muslim countries

Managing an Islamic enterprise

Islamic management as a distinct management style

Islamic Perspectives on Management and Organisation by

Abbas J. Ali, published by Edward Elgar (2005)
http://www.islamist.org/http://www.islamist.org/

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Managing an Islamic enterprise

What is an Islamic enterprise?

The Islamic firm in Islamic economics

The Islamic firm is a nexus of Islamic contracts between

owners of factors of production, making them contractuallybound to cooperate within an organisation, and working withinthe legal limits imposed by the Islamic Sharia, to achieve awell-defined objective in terms of production of a good orservice.

Managing such a firm in an Islamic way is the subjectmatter of Islamic management

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The Islamic firm

Unambiguous contracts

Owners of factors of production within an organisation

Definition of property rights

Objective function Legal system (Fiqh)

Specification of rights and responsibilities

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Role of contracts in Islamic management

Writing unambiguous (Gharar-free) contracts is a first steptowards managing an Islamic enterprise

Islam recognises that there is no such thing as a complete

contract it, therefore, emphasises on unambiguouscontracts

Unambiguous contracts minimise the occurrence ofdisputes and conflicts within organisations

A variety of contracts like agency (Wakala), profit sharing

(Mudaraba), partnership (Musharaka), promise of reward orbonus (Jiala) provide an array of incentives to different

parties within an organisation

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DERIVING PRINCIPLES OF ISLAMICMANAGEMENT (1)

PRINCIPLE 1

Managers are required to identify and/or define objectivefunction of the firm to use for delineating consistent strategyfor operations.

Thus, adopting a mission statement is probably the mostimportant aspect of managing an Islamic enterprise

It should differentiate between an Islamic and aconventional business

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Mission statement of GFH

Our mission is to remain one of the regional leaders in

Islamic banking and participate in the economic,infrastructural and social development programmes of theGulf Cooperation Council, Middle East and North African

countries. Gulf Finance House aims to maximise clients and

shareholders value in accordance with the principles of

Shariah, contribute towards the global growth of Islamicbanking and provide a challenging environment to ouremployees encouraging innovation and realisation of

potential.

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Mission statement of ABC

Our mission is to

Consistently generate increasing value for ourshareholders

Specialise in Arab-related activities across the world Invest in international financial institutions that diversify

and enhance shareholder value

Attract an retain high quality employees by providingrewarding careers

The two mission statements clearly differentiate between thetwo businesses

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PRINCIPLE 2

Clear and unambiguous definition of rights andresponsibilities of each group of actors within an organisationis essential for efficient and effective use of resources.

It helps in reducing moral hazard and slack in organisations

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PRINCIPLE 3

Devising incentive mechanisms like profit-relatedremuneration packages and performance-related bonuses,and effective monitoring are important for successfulmanaging.

It further helps in minimising the agency problem

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PRINCIPLE 4

Decision-making is a horizontal process in which those withright qualifications are consulted by the leader.

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Decision-making

Approval/Ratification

BOARD OF DIRECTORS

Owners and their representatives

EXECUTIVE BOARDA team of top management

Recommendations

SHRA BOARD

Representatives of workers, supervisorsand managers

Consultation

Recommendations

Supervisors ManagersWorkers

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PRINCIPLE 5

Improvement of quality of human resources primarily throughpersuasion, education and creation of a proper enablingenvironment within an organisation is fundamental to Islamicmanagement.

Islam recognises that there is no such thing as a completecontract it, therefore, emphasises on unambiguouscontracts

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PRINCIPLE 6


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PRINCIPLE 6


Islam recognises that there is no such thing as a completecontract it, therefore, emphasises on unambiguouscontracts

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SUMMARY AND CONCLUSIONS

The emergence of Islamic banking and finance requiresmanaging of the Islamic financial firm in accordance withIslamic principles of doing business

Although a distinct Islamic management style has yet toemerge, there is a growing awareness of the need for theIslamic way of managing Islamic firms

The literature on Islamic economics is sufficiently rich to offera starting point for developing an Islamic managementparadigm

A natural starting point is to look into the theory of the Islamicfirm to get implications for the development of principles ofIslamic management

Lecture-5 (Nov 7, 2005)[1]

Documents

Transcript of Lecture-5 (Nov 7, 2005)[1]