Tuesday, March 18, 2014

The concept of 'no risk, no gain' in Islamic finance

by muhammad hisyam mohamad - Leaving out the element of risk could lead to interest-based transactions, which are prohibited in Islam. IN one of his sayings, the Prophet asserted that entitlement to the return on an asset relates to the risk of ownership or al-kharaj bi al-dhaman. Based on this hadith, Muslim jurists developed a legal maxim al-ghurm bi al-ghunm or “gain is justified with risk”. Both imply that the entitlement to a return is related to the liability of risk. Simply put, in Islam, if there is no risk, there will be no gain. The hadith also provides a clear stance in Islam regarding its recognition of risk for justification of earnings in any economic venture. Indirectly, it also entails that in the absence of risk in business undertakings, one may find oneself in a circumstance that might give rise to interest-based transactions, which is strictly prohibited in Islam (Quran, 2:275-279). Nowadays, the notion of “no risk, no gain” is widely applied by Islamic finance and banking institutions through the concepts of mudarabah and musyarakah. Mudarabah is based on the profit-sharing principle, whereby the rab al-mal (owner of capital) and mudarib (enterpreneur) share the profits on a pre-determined ratio mutually agreed upon by both parties. However, in the event of loss under normal circumstances, it would be borne solely by the capital provider, while the mudarib would suffer reputational loss within the business community, which is non-pecuniary in nature but has a devastating impact on his image. On the other hand, musyarakah is based on the profit-loss sharing principle. Profit in such a partnership is shared based on the contractual agreement but the liability of loss is proportionate to the capital contribution. There are two more major kinds of Syariah-approved business approaches — sale-based and leased-based. In both categories, finance institutions are also expected to assume certain risks such as ownership risk to justify the returns earned from the contract. In sale-based contracts such as deferred payment sales (bay’ al-ajil), forward sale with cash advance (salam) and manufacturing financing sale (istisna’), profits are earned via the mark-up mechanism or murabahah. According to Kahf (2006), murabahah is the most popular mode of financing in Islamic banks today, occupying up to 90% of the total financing in certain banks. One reason for this is that the mark-up concept enables financial institutions to create exorbitant incomes. Islam also allows leasing or al-ijarah as a form of financial contracting. The Securities Commission Malaysia defines al-ijarah as “a manfaah (usufruct) type of contract whereby a lessor (owner) leases out an asset or equipment to his client at an agreed rental fee and predetermined lease period based upon the `aqd (contract). The ownership of the leased equipment remains in the hands of a lessor”. When analysed, each category of the above-mentioned contracts has its own distinguished criteria that are well-suited to the clients’ diverse needs and preferences. Nevertheless, as a fast-growing sector, industry players sometimes overlook the Islamic worldview of economics centering on the concept of amanah, which ultimately ends with al-falah. Among other things, this worldview states that social gain has preference over private benefit and cooperation over competition. To deny banks from making profits is untenable, but they must strike a balance between profit maximisation and social gain. According to Hasan (1985), in a system where interest and profit-loss sharing financing co-exist, the aggregate profit sharing ratio is a function of the overall rate of returns on investment, rate of interest, degree of leverage and risk premium. But when banks are used to this cheap money policy — paying depositors a low rate of returns and charging high prices on the financing side — it might create a problem of distributive justice as the return to bank shareholders’ capital magnifies tremendously. The sale of a commodity on the basis of murabahah is allowed in Islam. In fact, it is a pre-Islamic practice and can either be done with immediate, instalment or deferred payment, spot or future delivery. But when the sale structure is compromised, we can question the halalness of such a contract. For instance, in commodity murabahah (CM), there are elements of bai’ al-Inah (sell and buy back) and tawarruq munazzam (pre-arranged tawarruq), in which the financial institution buys a commodity and sells it to the client on a deferred payment basis. The client then appoints the financial institution as his agent to sell the commodity to the third party for cash at a price that is normally lower than the deferred price, which defies the concept of realism in Islamic economics and finance. In CM, the contracting parties do not intend to own the commodity. In fact, no delivery takes place. The pre-arranged nature in the contract is only a means to allow interest taking and does not stick to the concept of realism expounded by the Syariah (Kahf, undated). This is similar to ijarah. Even though the Quran and prophetic traditions validate the legality of ijarah, often we notice banks violating certain Syariah stipulations attached to the concept. For a valid ijarah contract, the bank as the lessor must bear the risk related to the ownership of the leased asset. Whether it is a sale contract or lease contract, the rule of al-kharaj bi al-daman and al-ghurm bi al-ghunm applies to both situations. In reality, the al-ijarah contract in Islamic banks adopts the same risk structure as the conventional leasing facility offered by its conventional counterpart. As such, it is not uncommon for the lessee to keep paying the rental or servicing the instalment payments to the bank though he is denied the use of the leased asset as it no longer exists due to force majeure damage. The bank takes no responsibility to offer any replacement asset or inform the client to discontinue the rental payment. In its original objectives, contracts approved by Syariah suit the diverse needs of people. Defective structuring and indiscreet use of these contracts, as explained by Hassan (2008), have made Islamic finance more exploitative and akin to the conventional system. In view of this, Islamic finance should operate within the Islamic worldview. Any divergence from Syariah guidance would definitely jeopardise the industry’s future as people will be skeptical towards its original role — to create a banking system free from exploitation. Muhammad Hisyam Mohamad is Fellow with Ikim’s Centre for Economics and Social Studies. The views expressed are entirely the writer’s own. (source: February 25, 2014 The Star)

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