Islamic Capital Markets

A Comparative Approach

Obiyathulla Ismath Bacha, Abbas Mirakhor

• Publisher: WSPC
• Year: 2019
• ISBN:
  9789813274655
• Edition: 2
• Topic: Business
• Subtopic: Islamic Banking & Finance
• Index: Business

Islamic Capital Markets: A Comparative Approach (2nd Edition) looks at the similarities and differences between Islamic capital markets and conventional capital markets. The book explains each topic from both the conventional and the Islamic perspective, offering a full understanding of Islamic capital markets, processes, and instruments. In addition to a full explanation of Islamic products, the book also ensures a holistic understanding of the dual markets within which Islamic capital markets operate.

Ideal for both students and current practitioners, the second edition of the highly successful Islamic Capital Markets: A Comparative Approach fills a large gap in the current literature on the subject, featuring case studies from Malaysia, Indonesia, Europe, and the Middle East. One of the few comprehensive, dedicated guides to the subject available, the book offers comprehensive and in-depth insights on the topic of Islamic finance for students and professionals alike.

Contents:

• Founding Thoughts: Adam Smith, Capitalism, and Islamic Finance
• Capital Markets: Introduction and Overview
• Islamic Finance: Underlying Philosophy, Contracts, Instrument Design, and Requisites
• The Interbank Money Markets
• The Islamic Interbank Money Market
• Bonds and Bond Markets
• Sukuk and Sukuk Markets
• Issues in Sukuk Design and Trading
• Common Stocks and Equity Markets
• The Islamic Equities Market
• Derivative Instruments: Products and Applications
• Shari'ah -Compliant Derivative Instruments
• Exchange Rates and the Foreign Exchange Market
• Capital Markets and Government Policy
• Potential Role of Capital Markets in Reducing Income and Wealth Inequality

Readership: Students and professionals interested in Islamic Banking, Islamic Investments and Islamic Capital Markets. Islamic Finance;Capitalism;Capital Markets;Interbank Money Markets;Islamic Interbank Money Markets;Sukuk;Bonds;Islamic Equities Market;Equities Market;Shariah-Compliant;Shariah;Derivative Instruments;Islamic Capital Markets0 Key Features:

• Fills a gap in the current literature on the subject with comprehensive coverage and in-depth explanations and insights
• Takes a comparative and holistic approach to the subject and features case studies from Malaysia, Indonesia, the Middle East, and Europe
• The second edition includes updates such as the latest in thinking and examinations of new proposed instruments

Chapter 1

FOUNDING THOUGHTS: ADAM SMITH, CAPITALISM, AND ISLAMIC FINANCE

Topics in this Chapter

1.1The Roots: The Economy, Real and Financial Sectors, Risk and Islamic Finance

1.2.Uncertainty and Risk

1.3.Why Do Uncertainty and Risk Exist?

1.4.Types of Risk

1.5.Risk in Real and Financial Sectors

1.6.Financial System of Capitalism: The Foundations

1.7.Smith and Arrow

1.8.Smith and Ethical Rules

1.9.An Arrow–Debreu Economy

1.10.What Happened to Smith–Arrow Risk-Sharing Ideal?

1.11.Can Economics Explain a Positive Predetermined Rate of Interest?

1.12.Islamic Finance: The Foundations

1.13.Islamic Rules Governing Exchange

1.14.Islamic Financial Market and Instruments

1.15.Islamic Finance Industry at the Present

Chapter Objective

This chapter is designed to introduce students to the conceptual basics of the linkage between the real and financial sectors. On completing this chapter, you should have a good understanding of the framework and theory of capitalism and a comparative understanding of the foundations of Islamic financial system

	Key Terms
Arrow-Debreu model	globalization	real sector
capitalism	intermediation	risk-sharing
complete contracts	invisible hand	Theory of Moral Sentiments
complete markets	markets and exchange	transparency
contracts and trusts	property rights	uncertainty and risks
financial sector	Qur'an and Sunnah

1.1.The Roots: The Economy, Real and Financial Sectors, Risk and Islamic Finance

This book is about capital markets, a vital part of any economy. As Chapter 2 explains, an economy can be thought of as being composed of a real sector and a financial sector. The former is where goods and services are produced. The financial sector, on the other hand, facilitates real sector activities through provision of financing.

In any society, there are “surplus units”, i.e., those who save surpluses remaining from their income after expenditures. There are also those who are “deficit units” in the sense that they are either spending more than the income they earn or are in need of funds to complete or initiate projects in the real sector of the economy. The important function of the financial sector of an economy is to act as an intermediate between these surplus and deficit units. It does so by providing short-term funds in the money market and medium-to-long-term funds through the capital market. In effect, the financial sector allows the surplus units to postpone their expenditure plans while making it possible for the deficit units to bring their expenditure plans forward. Both do so through the money and capital markets.

Up to the 1970s, the primary function of capital markets was to act as an intermediate for surplus funds by channeling them to investment, i.e., to create additional capital (capital formation) in the real sector of the economy. This, in turn, created additional employment and income. This is the economic understanding of the concept of investment. In day-to-day conversation, however, the word “investment” refers to purchases of any asset instrument that represents a flow of future income. For example, it may refer to purchases of already existing bonds or shares of stocks. This is not an investment in the economic sense but a transfer of ownership of existing assets, a process that does not necessarily lead to creating additional productive capacity and, thereby, additional employment and income.

Since the 1980s, much of the growth of capital markets has been attributed to a rapid increase in the latter types of transactions to the point that only a very small portion of the large volume of transactions in capital markets end up in new capital formation. In fact, a famous innovator and major market participant calls this type of ownership transfer “speculation”, and considers that there is now a “clash of cultures” of investment and speculation in the market (Bogle, 2012). The difference between the two is that investment expands capital formation and increases employment and income, but speculation does not. Investment increases the income of the investor, jobholders, and households, while speculation increases the income of the asset holders (usually the rich).

What has become painfully clear during the post-2007/2008 financial crisis is that how well a financial sector performs its primary function of intermediation determines the stability of the financial sector and, consequently, that of the entire economy. Many economists believe that a major underlying cause of the crisis was that the relation between finance and real sector activities has become increasingly weakened in the last four decades.¹ Financial sector has grown much more rapidly than the real sector and has taken a life of its own; the sectors have decoupled. This phenomenon, driven by speculation, is referred to as financialization of the economy.² A crucial auxiliary function of the financial sector is to provide ways and means by which members of the society manage financial risks they face. Instruments developed in the financial sector are designed to perform this function. An understanding of risk is elemental to comprehending the role and functioning of the financial sector.

1.2.Uncertainty and Risk

Decision-making is one of the most fundamental capabilities of humans. Actions follow decisions. Individuals have to make decisions and take actions that affect their own as well as others’ lives at some point in the future. However, the future is, for the most part, unknown, and therefore unpredictable and uncertain. Uncertainty is a fact of human existence as we all live on the brink of a future about which our information is dominated by ignorance. Facing an unknown and often unknowable future, individuals still have to make decisions and take actions. This they do by forming expectations about the payoffs to alternative courses of action.

Expectations can be formed by individuals objectively or subjectively. In the first case, the expected payoffs are based on known probability techniques, as in the insurance industry. Alternatively, individuals can base their expectations of payoffs to alternative decisions based on their own or others’ personal experiences. Either way the expected outcomes will form expressions in terms of the probability of occurrences of the consequences of actions. Through this process, uncertainty is converted to risk. Therefore, risk is a consequence of choice under uncertainty. It is uncertainty about the future that makes human lives prone to risk.

Risk would arise because the decision-maker has little to no information regarding which state of affairs will materialize in the future. The individual nevertheless makes a decision and takes appropriate action based on expectations. Risk can also arise because the decision-maker does not or cannot consider all possible states or outcomes that may prevail in the future. There may be so much missing information that it is impossible to form expectations about payoffs to decisions and actions. This situation is referred to as ambiguity, which may lead to paralysis in decision-making. One way of dealing with ambiguity caused by missing information is patience; postponing decisions until more information becomes available.

1.3.Why Do Uncertainty and Risk Exist?

How can uncertainty and its overwhelming influence in human life be explained? Why is life subjected to so much uncertainty? These are particularly significant questions for those believing in “intelligent design” or in a Supreme Creator. Why is uncertainty created for humans? Bartholomeu (2008, p. 230) suggests that “risk is a necessary ingredient for full human development. It provides the richness and diversity of experience necessary to develop our skills and personalities”. Moreover, he argues (2008, p. 200, p. 239) that the “development of human freedom requires that there be sufficient space for that freedom to be exercised. Chance seems to provide just the flexibility required and freedom; risk is the price we pay for freedom”.

Similar reasoning is clearly discernible from the Qur’an. Freedom is a crucial characteristic of human dignity bestowed by the Supreme Creator. The right path, and the rules of traversing it, is prescribed and differentiated from the wrong path. It is then left to humans’ freedom of choice to make decisions as part of their rights and responsibilities. Uncertainty and risk exist to allow humans to learn as they are confronted with choices. This process is termed “testing” in the Qur’an. Humans choose under uncertainty. Their choices determine the consequences. Confronted with a choice, they are tested as to the path they select. The test is whether or not they choose to act in accordance with rules prescribed by their Creator.

Clearly, individuals exercise their freedom in choosing to comply with these rules. In a number of verses, the Qur’an asserts that life on this earth is temporary. As such, it is a crucible of constant testing, trials, and tribulations (see, e.g., Verse 155, Chapter 2 and Verse 2, Chapter 76). Not even the believers are spared testing. In Verse 2 of Chapter 29 the Qur’an asks: “Do humans think that they will be left alone when they say: we believe, and they therefore will not be tested?” To every test, trial, and tribulation in their lives, humans respond, and in doing so, they demonstrate a measure self-awareness and consciousness of their Creator. If the response–action is in compliance with the rules prescribed by the Creator, then the test becomes an occasion for self-development and strengthens consciousness of the Creator. All actions are risky because the full spectrum of future consequences of actions, within the horizon of birth to eternity, is not known with certainty. As the Qur’an asserts “…at times you may dislike a thing when it is good for you and at times you like a thing and it is bad for you. Allah knows and you do not” (Verse 216, Chapter 2). In short, human life here is a time to be tested, and to learn and develop through the exercise of freedom of choice granted to humans by their Creator. Crucially, testing is not possible without risk and uncertainty.

1.4.Types of Risk

Individuals in any society face two types of risk. The first is systemic, the result of the exposure of the economy to uncertainty and risk due to external and internal economic circumstances of the society and its vulnerabilities to shocks. How well an economy will absorb shocks depends on its resilience, which depends on the institutional and policy infrastructure of risk management in the society. How flexibly the infrastructure will respond to shocks will determine how much this type of risk impacts individual lives when it materializes.

The second type of risk individuals face relates to the circumstances of their own lives. These include risk of injuries, illness, accidents, bankruptcies, or even change in tastes and preferences. This kind of risk is referred to as idiosyncratic, and when it materializes, they play havoc with people’s livelihoods. This is because people’s livelihoods, and therefore their consumption levels, often depend directly on their income. If income becomes volatile, so will their livelihoods and consumption levels. Participation in capital market activities can help mitigate idiosyncratic risk by diversifying the source of income. Capital market instruments, when purchased by individuals, reduce the correlation between income and consumption and strengthen the resilience of their lives to idiosyncratic shocks. Thus, when shocks reduce income, consumption levels of the individuals invested in capital market need not suffer.

1.5.Risk in Real and Financial Sectors

As mentioned earlier, there are two major sectors in the economy. The real sector is where goods and services are produced.³ Until very recently, the major function of the financial sector was to facilitate the financing of projects. The decision to take risks to produce a product precedes the decision on what to do with the risk in financing the project. Once the decision to undertake a project in the real sector is made, a subsequent decision has to be made as to the mode of financing. The risk taken in the real sector has to consider risks associated with the business end of the project. The firm or the entrepreneur can finance the project from their own sources or seek external financing. The risk of financing can be transferred, shifted, or shared. Figure 1.1 shows how risks that originate in the real sector get transferred, shifted, o...