A Growing Level of Financial Engineering and Risk Management - Research Paper Example

 Islamic banks can provide efficient banking services to the nation if they are supported with appropriate banking laws and regulations. This will aid them to introduce PLS and other Islamic modes of operation, which are very conducive to economic development. In order that the Islamic banking system fully utilize its potential, it is preferable that Islamic banks have the opportunity to work as the sole system in an economy, as studies show that Islamic banks cannot, relatively, operate with full efficiency under a conventional banking framework especially the case of Islamic windows which exposed to close out in Qatar for example. However, in some cases Islamic banks can operate with a relatively limited efficiency facing a variety of regulatory challenges, but still they wouldn’t be operating as ideally efficient banks. This decrease in efficiency is not due to mechanical deficiencies inherent within Islamic banking, but to the inefficient operation of the conventional banking system, which obstructs the operation of Islamic banks as the symptoms of a conventional banking system pervades to Islamic banks likewise the conventional banks. This does not mean that the survival of Islamic banks operating within the conventional banking framework is threatened. Some regulators try to overcome this by adopting a separate Islamic banking regulatory framework parallel to that of the conventional banks. Ahmed stated that the challenge for Islamic law was to create financial contracts from traditional nominate contracts to meet the modern day needs of financial markets and intermediaries. Recent history of the growth of the Islamic financial sector is an indicator of the adaptability of Islamic law to changed situations. Given the principle of permissibility, Islamic commercial law can evolve as long as the limits imposed by Shariah are not traversed. The adaptability features of source of law and legal justification for Islamic law were closely examined. While contemporary Shariah scholars and jurists have done an admirable job of modifying the classical nominate contracts into financial contracts, there still remains a lot of work to be done to make Islamic commercial law relevant to modern day needs. To enable this, there is a need to develop Islamic law, keeping in mind the maqasid al-Shariah and the existing technology and environment. The renowned theory by Lon Fuller that is titled the “inner morality” of the Rule of Law clearly stipulates that a legal system will fail if laws presented within the system are obscure, and contradicting. Therefore, to ensure that Islamic banking maintains its unique nature it has been critical to devise a legal framework that ensures efficient functioning of Islamic banking, which is in conformity with Islamic teachings. We can look into the key elements that are contained within a legal framework to support efficient functioning of Islamic banking. Aldohni stated that under the Islamic banking act, Islamic banking business is described as a banking business whose operations and objectives only contain elements that have been approved by the Islamic religion and in particular, the Shariah laws (63-65). Therefore, the main elements within the legal framework for efficient functioning of Islamic banking draw their origin to the Islamic religion. The most predominant element of the legal framework for Islamic banking is prohibition of the issuance of interests on all forms of transactions within Islamic banks. This element within the legal framework ensures the efficient functioning of Islamic banking in a manner that conforms to Islamic teachings and it helps in differentiating Islamic banks from the other commercial banks (Aldohni, 68-71). This differtiation would lead to figuring out to the public the equitability and avoidance of Ghara in Islamic banking as compared to conventional system conventional banking legal and regulatory framework. Moreover, one of the key elements within the legal framework is that all Islamic banks are expected to undertake business and trade activities with the main objective of generating legitimate profits. Therefore, efficient functioning of Islamic banks is based on the premise that banks offer services, which are genuine and charge reasonable costs (Aldohni, 74-76). Furthermore, one of the key elements of a legal framework for efficient functioning of Islamic banking is that while Islamic banking is critical to materializing the economic objectives of Islam, it is not the whole of the Islamic framework. Compared to conventional banks, it is viable in isolation, but its full potential can only be realized by supplementing it with corresponding reforms in other spheres of life in general like social responsibility as well as in the monetary and fiscal field in particular. While Islamic law can evolve based on a rich source of body of legal theory and rulings, other elements of the legal infrastructure like laws and statutes, harmonizing the Islamic rules related to financial dealings, and dispute settlement institutions are still weak in many countries. The adaptability features of Islamic law have to be complemented with the strengthening of the legal infrastructure to ensure the development of a comprehensive Islamic financial sector. Given the noble objectives of Islamic law, its evolution can help produce an alternative financial system that can benefit not only Muslims, but humanity at large. References Ahmed, Habib: Islamic Law, Adaptability and Financial Development, Research Paper, Islamic Economic Studies Vol. 13, No. 2, February 2006 print. Aldohni, Abdul. The Legal and Regulatory Aspects of Islamic Banking: A Comparative Look at United Kingdom and Malaysia. London, Routledge. 2012 print Waldron, Jeremy. Theory & Practice in British Politics: The Law. London: Routledge. 2012 print. 1- Are traditional nominate contracts sufficient to develop contemporary financial products or there is a need to re-define fundamental concepts in Islamic law? The re-definition of fundamental concepts was necessary for Islamic contract law in regard to traditional nominate contracts as the Islamic law was forced to adapt traditional nominate contracts to new financial contracts. This was necessary for sufficient and satisfactory coping with the transactions of contemporary financial system. Ahmed stated that nominate contracts under civil law are simply contracts that are distinguished by a particular name such as lease, insurance, or sale. However, because of Islamic laws, the Islamic banks are forced to redefine the traditional nominate contracts to ensure that they conform to Islamic teachings and laws (56-58). Because of the specific requirements under Islamic laws and the elements within the legal framework for Islamic banking, Ahmed stated that traditional nominate contracts are adopted for use in Islamic banks after their concepts have been redefined in a manner that suits contemporary transactions under Islamic teachings (71-73). An example of how traditional nominate contracts are redefined is the use of sale of arbon (advance payment) as a call option. In the application of the sale of arbon, a buyer of goods is paid a certain percentage of the total amount of the good with an agreement that he or she will purchase the good at a future date upon which the seller will fulfill his/ her obligation to sell the good. The example above is a clear demonstration of how a traditional nominate contract of which is the call option, is redefined in terms of its fundamental concepts to conform with Islamic laws so that it can be offered as contemporary financial product under the name of ‘sale of arbon.’ References Ahmed, Habib. Product Development in Islamic Banks. Oxford, UK: Oxford University Press. 2011 Print 2- Discuss the legal and Shari’ah issues arising in developing sukuk structures. According to Islamic financial Services Board (IFSB), sukuk refers to the certificate that represents the holder’s proportionate ownership in an undivided part of an underlying asset where the holder assumes all rights and obligations to such asset. Over the years, the increasing growth of the Islamic financial market has seen sukuk emerge as one of the key instrument in the debt market. However, the integration of the sukuk structures into the formal financial market has resulted to emergence of numerous shariah and legal issues. The development of sukuk structures focuses on addressing three key issues, which pertain to sukuk holders, stipulations guiding asset disposal and the management and operation of these assets. According to Nethercott and Eisenberg, the development of sukuk structure is intricately based on the shariah laws since sukuk is of Islamic origin. One of the key issues that results from the shariah laws is the observation of the Qabd concept. In Arabic, qabd translates to “to take possession.” This law guides the possession of the goods and services in the Islamic society. According to the Koran, one was prohibited from selling food that she/he had not received. Islamic scholars and religious leaders further implemented the law to forbid sukuk holders of asset based structures from receiving interests from their related assets. Hence, the interpretation of this law is critical in the determination of valid sale of contract with respect to sukuk structures. The development of sukuk structures further presents some legal implications that may be present in the shariah laws or be absent. Typical example of a legal issue is the restrictions put on asset disposal. Majority of sukuk structures do not permit sukuk holders to dispose of the asset. Critical examination of the structure indicates that this is not a shariah requirement. However, the legal authorities regulating the financial market normally enforce the clause. There is a need to revisit the regulatory and legal challenges that face Sukuk global market growth and tried to provide solutions for regulatory conflicts that is inherited in Sukuk structure and its derivatives engineering. Noticeably, western governments have taken regulatory steps to accommodate the issuance of international Sukuk in their local markets to mainly attract the liquidity surplus from the GCC countries to finance the local sovereign and corporate debt in the west. Some major western institutional investors such as HSBC, Citigroup, Deutsche Bank, UBS, Goldman Sachs and Standard Chartered have adapted their asset management services to provide Sharia’ah compliant asset and wealth management services. However, beside this rapid growth and on-going global attention to Sukuk market there are challenges that lie ahead, Starting from developing some of the existing structures, innovation of new Sukuk structures and Sharia’ah compliant derivative instruments to provide genuine and efficient alternative investment instruments. In addition the existing involvement of Sharia’ah scholars in the Sukuk structure development and approval creates an obstacle for the Sukuk global market growth and specifically in meeting the international standards. So, there we should differentiate between conventional bonds and sukuk as bonds are financial obligations in form of certificates issued by borrowers to creditors, and one of its major features is the guarantee feature where creditors guarantee capital repayment with capital charges to the borrowers. Thus, the objective of bond is to gear up the issuer leverage through a loan relationship with the characteristics of earning money for money which is a practice of Reba. While sukuk represents asset ownership passed from issuer to sukuk holder in form of sharia compliant contract such as lease, partnership, and sale contract which originates from trade / business activities. Thus, the return derived of real underlying assets which characterized sukuk as an asset-backed financing instrument. Sukuk not always debt instrument it could be equity instrument depending on how sukuk are structured. Interestingly enough, it is observed that pure Sukuk portfolio is significantly riskier than a pure bond portfolio. This may be due to factors which stems from the characteristics of Islamic finance that underlines Sukuk structuring and engineering also sukuk not involving only credit risk but also market risk, asset quality risk, regulatory risk (Tariq and Dar (2007). Enforceability of sukuk and which law could be enforced in case of sukuk issuance for cross-border transactions which may cause legal impediments due to the inability to obtain satisfactory legal opinions which emanate from the sales of assets between the originator & investors through the SPVs. Khan (2007) and Jobst , Kunzel ,Mills and Sy (2008) also addressed the conflict of diversity in Sharia’ah scholars opinions and argued that despite this mis-matching between Sharia’ah scholars opinions, this diversity has contributed to the global growth of Islamic finance instruments. However, Khan (2007) argued that this could become a constraining factor in the global growth if the challenges arise out of diversity in Sharia’ah scholars are not institutionally recognized and regulated. The absence of Islamic finance derivatives has also been a subject of debate among scholars. Executing a true sale is a crucial element in sukuk as it constitutes a real transfer of ownership from the originator to the sukuk holder via SPV. However, some sukuk issuance does not execute a true sale as with asset-backed sukuk issuance due to the absence of property law and bankruptcy law under civil law regimes. Thus, in case of bankruptcy, the court follows the legal precedent that the financing is not a sale contract but a secured disguised loan in a true sale. Example of that is Nakheel sukuk defaults case in UAE which caused legal uncertainties where the sukuk holder right to claw back the assets are not protected when Nakheel company declared its bankruptcy. There is a fact that when investors purchase sukuk they are interested in the risk related to the issuers instead of the underlying assets or project undertaken due to prevalence of asset-based sukuk. This is due to the fact that the methodology used by rating agencies for sukuk is similar with conventional bond rating since there is no independent sukuk rating agency which should shift the paradigm of sukuk rating where the risk proxy is based on feasibility and prudential evaluation of the asset instead of originator risks. Also compliance with sharia and legal uncertainties are important proxies to be incorporated in sukuk rating methodology particularly on how the sukuk issuance can protect the investors & resolve the legal conflicts in the event of bankruptcy. Sukuk need to be standardized & streamlined in term of legal documentations and shaira standards. This is due to legal uncertainties and conflicts arising from sukuk transactions as well as shaira divergences & enforcement of the standards is critical at the moment for having sharia compliant sukuk in the market. Besides, there should be uniformity of law for offshore jurisdiction as well as methods to resolve the conflicts of legal systems that applies to all sukuk issucance across all jurisdictions. In case of sukuk default, it could be resolved in pursuant to a standardized legal documentation. Such procedure would generate certainties, predictabilities, and sharia convergence through sukuk standardization.R&D should move further to come up with a new product in a way that will not face more contradictions with the conventional law. Some countries tried to come up with new rules that suits the issuance of Islamic Financial Instruments. E.g. in USA they changed some termonologies like finance charge instead of interest. In UK they modified the tax law to accommodate the property tax relating to the underlying assets of Sukuk. Work cited Nethercott, Craig and Eisenberg, David. Islamic Finance: Law and Practice. Oxford University Press, U.S. 2012 Print 3- What are the problems that can arise in adjudicating disputes involving Islamic financial transactions in non-Islamic (common law and civil law) legal jurisdictions? The adjudication of disputes involving Islamic financial transactions in non-Islamic legal jurisdiction has always faced challenges ranging from contradiction, prejudice, and lack of an appropriate legal system. However, most scholars have observed that the limitations of the Islamic financial structure have been the precursor of the challenges facing the system. It is worth mentioning that in some Islamic financial transactions disputes often takes place on a global level with parties originating from different regions in the world. Thus, what creates problem is the diverse backgrounds of the parties involved and the potential variety of legal jurisdictions. The great problem of using sharia finance under common law or civil law jurisdiction can be shown in two aspects: one is that lack of special Islamic courts to enforce Islamic contracts increase the legal risks due to the fact that Sharia is a set of moral and religious principles rather than a codified body of law. Therefore, the law of country will prevail over principles of sharia, and second thing is the conflict that emerges between sharia law and common law (which is know of its sanctity of contracts) or civil law ( which is difficult to judge without a detailed codes or statutes on Islamic finance) as they are always prevail over sharia law when there are disputes. As a result, the contract is interpreted solely based on what is written in the contract irrespective of sharia regulations. This can be seen in the case of Shamil Islamic Bank of Bahrain VS Pharmaceutical company , in this case the defendant was not be able to make payment for his financing to the bank and the court judged based on English law instead of Islamic law. The defendant argued that the contract was so worded with sharia principles as not to clash with English law. However, the judge ruled that there cannot be two separate laws governing one contract and that the national system is the valid law to govern the contract. This conflict between common law and sharia leads to unreality. Thus, the verdict was decided based on sale contract law while the substance of the contract was actually a conventional debt contract. Therefore, confusion emerged as to the legal basis of the verdict. One of the challenges that are likely to occur in the adjudication of Islamic financial transaction in a non-Muslim state is biased ruling. In most cases, the resolution of financial disputes involving non-Muslim and Muslim parties is always heard in secular courts. The ruling of financial disputes in civil courts is based on the constitution. Nethercott and Eisenberg observed that the rulings of such disputes are always biased due to contradiction of the shariah law and the civil law. According to sukuk structure, holders of asset-based structures are not entitled to receive interest from their assets. However, in a civil court this concept may not be considered and thus lead to unjust ruling. Adjudication of Islamic financial transaction in a non-Muslim court could further face the challenge of limited documentation. Generally, currently there exist limited documented materials relating to Islamic financial institutions. Prompt resolution of financial disputes may be hampered by lack of relevant authorized material necessary in the ruling of a given cases. In other cases, the prosecution or defense team may lack precedential rulings, which could aid in the current adjudication. Due to public pressure and political stability, the adjudication of a financial transaction disputes related to Islamic party may be inappropriately delivered. Most civil court judges and prosecution teams lack comprehensive knowledge relating to Islamic shariah. In an attempt to avoid public outrage or seek religious support, a civil judge may misinterpret the shariah law and pass a ruling that might harm both parties or favor one of the parties. Examples when Civil law system governs Islamic financial case: In UAE (Abu Dhabi the federal supreme court) the dispute was in a diminishing musharaka (partnership) arrangement. The customer owed rent to the Islamic financial institution which was secured by mortgage. However, the court considered the proper interpretation of the contract was a loan secured by mortgage over land. Another example in UAE the case was judged by the court of first instance in Dubai, the main dispute was ‘’is the lease to own contract a lease contract or installment sale?” The court considered the agreement as a sale contract due to the contractual relation and the intentions of the parties, which made the lease contract as undertakings of sale and purchase. To conclude, it is worth mentioning that in some Islamic financial transactions disputes often takes place on a global level with parties originating from different regions in the world. Thus, what creates problem is the diverse backgrounds of the parties involved and the potential variety of legal jurisdiction Work cited Nethercott, Craig and Eisenberg, David. Islamic Finance: Law and Practice. Oxford University Press, U.S. 2012 Print 4- Are banks capable of managing their risks or there is a need for regulatory overview? In the writings by Bessis, he addressed the key question about banks capabilities in managing their risks by giving reference to the 2007 to 2009 global financial crisis, which was largely caused by banks failure in managing their own risks (110-114). Bessis further added that prior to the global financial recession banks were engaged in risk behaviors blinded by the desire to report increased profits, as it had been the trend in the past few years. However, after an overstretch of the risks limit, major banks started reporting shortage in liquidity, which subsequently, lead to collapse of some of these major banks (156-161). Therefore, there is need to maintain regulatory overview in the way banks manage their own risks. Banks need regulatory overview due to several facts: The need for regulatory overview is necessary because of the pressure that banks get from shareholders who are in dire need of improved earnings. Therefore, to ensure that the banks do not surpass the stipulated risk limits, the regulatory body or legal framework require banks to maintain a certain minimum requirement of capital at the central banks, which depends on the prevailing market risk in order to ensure that the banks stay within their limits (Bessis, 212-217). Moreover, considering the integral role that the banks play within the entire economy of a country it is highly recommended that they should be put through a vigorous regulatory overview in order to safeguard the economy of the country, which is largely driven by financial institutions. To conclude, Risk has become a growing concern for most financial institutions today whether this concern comes from the increasing competitive market place or from the imposed stringent regulations. The banks need to have robust risk management framework in place if they wish to survive in a more interconnected and complex world that including a growing level of financial engineering which challenges risk systems to the extremist level. Banks usually look for returns regardless of people’s profitability; on the other hand, regulators protect depositors’ funds as banks are assumed to make profit using others’ money. Thus, here arises the ethical issue as banks may invest in risky projects. Work Cited Bessis, Joel. Risk Management in Banking. (3rd edition). Hoboken, NJ: John Wiley & Sons. 2011 Print Read More