Risk Management with Islamic Derivatives: Do We Really Need Them

Salman Ahmed Shaikh

Islamic finance industry assets are now worth more than $1 trillion. The industry has shown resilience and double digit growth even in the face of global recession.

However, there was much more expected from them on different grounds as IFIs built their reputation and gained acceptance from masses having promised socio-economic benefits of an egalitarian financial system based on Islamic principles.

In currently used debt based modes of financing, Islamic bank does not commit a single penny unless the customer signs the unilateral undertaking, and by way of unilateral undertaking, the customer is bound to purchase the asset and pay markup price of the asset to the bank which is calculated using KLIBOR/LIBOR as a discount rate and using present value annuity formula. Only when the customer agrees to provide that undertaking, will the bank think of purchasing the asset.

Islamic bank basically amortizes all its costs through rentals or markup price. It is acting as a financial broker looking to amortize an investment made. For the same asset or property, the bank will charge higher rentals for short term lease and lower for long term lease. It is because bank is willing to amortize all costs and not acting anything else than being a financial broker. The pricing for different tenures mimics the term structure of interest rates and what enables comparable returns is the provision of locking second leg of transaction in all lease and trade based contracts using the ‘unilateral undertaking’ which by all means is legally binding.

The Islamic banks have now become banks for the rich elite in urban localities and for the businesses which want to expand their size through ownership of ‘new’ assets. Islamic banks are not for financing education, health, micro enterprises and poor. Their clients are mostly blue chip companies which can obtain financing from many other institutions as well if Islamic banking even did not exist.

The so called asset backed nature of financing in Islamic finance deprives one to finance education, health, autonomous and necessary consumption. What it ensures is the rent seeking by Islamic institutions that insure the asset and add this insurance cost in the rentals and Murabaha price to make their income receivable as secure as interest on loan by mitigating price, market and asset risk which is the basic distinguishing feature between trade and Riba.

While Islamic banks maintain the strategic policy to mimic and copy conventional finance products and Islamize them and maintain highest banking spreads (at 8.4% in Pakistan in 2011) among the major countries of the world, all economic arguments in favor of Islamic banking are also equally supportive to conventional banking.

After substantial double digit growth in assets, customer base and profits, rather than embracing the vision to provide an egalitarian financial system with widespread use of equity financing, Islamic banks have now seemingly decided to continue mimicking conventional financial paradigm and offer sophisticated structured products and derivatives.

To put the issue in right perspective, financial sector earnings increased manifold in developed markets after Breton Woods system ended in 1971. These earnings are transaction costs for the productive sector. Even amidst these high earnings, the financial sector still could not do its job of matching credible business sector investors with savers.

Why? It is because financial intermediation grew in massive proportion and became increasingly delinked with productive sector. Financial institutions that were just supposed to be playing a supportive role to the productive economy got much bigger and unregulated through shadow banking practices in west.

Greed in capitalism is permanent. But, the very allowance and room to securitize financial obligations and be able to sell them to other financial intermediaries provided the necessary impetus for being reckless in credit penetration and pass on the toxic assets later on to others.

Now, what are the lessons to be learnt by Islamic finance from all this?

First, all product vetting and engineering must take into account the fact that entrepreneurial risk is the cornerstone of permissible earnings from any allowable business venture in Islam. This is best ensured through as direct a financial intermediation model as possible. It is hard to ensure it in a complex nested financial framework. This risk can only be eliminated at the cost of compromising the basic distinctions of Islamic economic principles.

Second, it is not necessary to use derivatives in most cases in Islamic Finance. Floating rate rentals can substitute use of interest rate swaps. Credit Default Swaps (CDS) are not needed in most cases since almost all financial assets credit creation is backed by real assets and the bank has recourse to them.

It is quite hard to distinguish between hedging and speculation because it depends on intention which is unobservable. Delivery based trade contracts ensure that the transaction is not for speculative purposes only. Price hedging can be ensured through Salam and Murabaha already which are used for short term financing. In long term financing as discussed before, the rentals are mostly floating. It is advisable to price products based on specific asset’s market fundamentals rather than using an interest based benchmark for all types of asset financing. This will not only be better from hedging perspective, but is also preferable from Islamic perspective.

Third, rather than waiting for the demand side changes, Islamic financial institutions having gained tremendous growth and penetration in recent past, must offer change from the supply side. They must begin offering equity financing and follow them up with standardized instruments with equity contracts as underlying.

For instance, initially established portfolio comprising equity financing assets could pool funds from other institutions and general public through issuing Musharakah certificates. These can not only increase widespread use of equity financing, but can also contribute towards better distribution of income and wealth and horizontal spread of risk and return.

Initially published in IFN Magazine, Malaysia.


About Salman Ahmed Shaikh

PhD Scholar in Economics and works as GRA at UKM, Malaysia. He can be contacted at: salman@siswa.ukm.edu.my
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2 Responses to Risk Management with Islamic Derivatives: Do We Really Need Them

  1. KnowledgeSeeker says:

    I wonder how this analysis will change if you incorporate the fact that banking industry is not operating on loanable funds theory any more, but Islamic as well as any so called intermediation done by banks is actually no intermediation at all.

    According to Modern Monetary theory, banks are not constrained by reserves they have in creating loans, which are just accounting procedures on bank’s balance sheet. The role of deposits is not to fund loans as the redundant ‘loanable funds theory’ explains, rather deposits are just one source of funds available to banks if their cost (interest paid on deposits) is cheaper than the cost of acquiring reserves from central bank. The role of reserves is just to facilitate payment system and not to fund loans. So technically the loans could be created without any constraint other than profitability of the bank.

    Any bank when makes a loan creates a new deposit for any borrower at the same time, so Islamic or not, banks create new money with the stroke of their keyboard, no deposits are required for this operation as a prerequisite, so there is actually no intermediation between savers and borrowers taking place for limited funds. This is deception too if such concepts are applied to Islamic banks as if they are pooling some funds and investing these into some business and the return is being distributed as profit.

    So even Musharakah certificate is some Islamic concept, but how it is different than the term deposits of conventional bank, not at all. The reason banks only care about deposits is explained in this blog, this is by Bill Mitchell, a proponent of modern Monetary theory which in my opinion correctly describes the process of money creation by banks and by the government which has thoroughly changed the concept of public debt as public equity. When government spends money, new money comes into circulation which is always paid to someone in the private sector. Banks on the other hand create new money as they create loans and deposits, but they charge interest on this money creation out of keyboard, just because they are allowed.

    Your feedback please on Modern Monetary theory?


    • Thanks for the detailed feedback. I agree that today’s currency system is fiat based. Modern banking is also not 100% reserve banking. Rather, it is fractional reserve banking and all money is created as debt. You raise a good point that financing from the credit money creation does not involve previously saved amount. However, the system runs in a way that every loan also creates an additional deposit in a friction-less banking system.


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