Can a shadow bank redeem the underdevelopment of the Muslim world?

Transcription

1 Can a shadow bank redeem the underdevelopment of the Muslim world? Muhammed Shahid Ebrahim University of Durham 26 July

2 I. Motivation The purpose of this conceptual note is to discuss a proactive way of harnessing the power of capital markets to build a better Islamic financial intermediation system. This will stem the long term decline in the growth of emerging Muslim economies and foster their development. This, in turn, will improve the lives of the citizens of these nations. 26 July

3 II. Current State of Muslim Economies The total GNP of the fifty-seven Muslim countries is only 8 percent of the world GNP, while their total population is more than 1.3 billion and constitutes about 21 percent of the world population. Identically poor results are revealed from an analysis of the Human Development Index (HDI), as defined in the United Nations Development Program (UNDP). Out of fiftyseven Muslim countries, twenty-one received low scores, thirty-one countries secured medium scores and only five Muslim countries attained high scores on the HDI. 26 July

4 III. Theoretical Assertions Financial systems play a vital role in advancing intermediation by mitigating market frictions, facilitating efficient investment decisions, allocating scarce capital and transmitting financial transactions. This in turn stimulates capital accumulation decisions and technological innovation that are crucial in delineating a nation s long term economic path. The efficient structure of the financial intermediaries (FIs) is thus of import for the welfare of its constituent economic agents (see Blejer, 2000). 26 July

5 III. Contrasting an Islamic Bank with an Investment Company 26 July

6 III. Step A Contrasting the Organizational Structure of an IB with that of an IC. An IB is a less efficient organizational form as compared to an IC. This stems from two issues: One: An IC is a flow-through or a pass-through entity, while an IB is a corporate entity. This mandates imposition of taxes on the profits of an IB but not that of an IC. This issue has major ramification on the pricing of the financial facilities of an IB at a higher level (in contrast to an IC). 26 July

7 III. Step A (Continued) Two: The second contract of Mudārabah on an IB is onerous. This is because when the savers of funds are asked to share in the risk of the facilities underwritten by an IB, they will require a higher return (in contrast to an IC). Three: ICs are less leveraged than banks and they do not own assets. This makes IBs relatively more unstable than ICs. Result A: The organizational form of an IB is competitively less efficient than that of an IC. 26 July

8 III. Step B One: The financial facilities invested by the IC can be more consistent with the spirit of the Shari ah than the ones predominately invested by an IB. The bulk (roughly 80% of the assets) of the IB comprise of a buy-sell agreement, involving a murabaha facility, which does not expunge the agency cost of debt and is tainted by the element of ribā (see Ebrahim 2016b). 26 July

9 III. Step B (Continued) Murabaha is akin to collateralized debt facility ameliorating asymmetric information (involving gharar attributed to adverse selection or/and moral hazard) but endemic in agency costs of debt. This makes it quite controversial as the prohibition of riba an-nasi ah (deferred ribā) is attributed to the potential of expropriation of assets of a lender or a borrower ensuing from the endemic agency cost of debt due to either risk-shifting or underinvestment respectively (see Ebrahim 2016b). 26 July

10 III. Step B (Continued) This is consistent with the Qura n (4:161, 30:39), which renounces ribā as it leads to expropriation of a counter-party s assets. This attribute of ribā is reflected in the Sunnah (see Thomas, 2006). It is also reinforced in the classic works of Ibn Taymiya (1951) and Ibn Qayyim (1973). 26 July

11 III. Step B (Continued) ICs investing indirectly in leasing (ijarah as explained below) (in contrast to murabaha by IBs) can moderate both asymmetric information (involving gharar) as well as the agency cost of debt (involving ribā). Leasing not only increase the debt capacity of a potential borrower but is also highly tax efficient (see Myers et al., 1976 and Eisfeldt and Rampini, 2009). This implies that ICs investing in leasing can offer higher risk adjusted rates of return to their ultimate stakeholders than IBs. 26 July

12 III. Step B (Continued) The above result not only ensues from the competitive advantage (in the form of tax benefits) of leasing over asset-backed loans (i.e., murabaha facilities) but also from the lower transaction costs of ICs over that of IBs ensuing from their respective organizational form. Two: The risk adjusted returns of an IC is expected to be competitively higher than an IB over the life cycle of the savers of funds. This is explained as follow. 26 July

13 III. Step B (Continued) The life cycle hypothesis, elaborated in Samuelson (1989), sheds light on how economic agents should employ portfolio theory in different stages of their life. Young agents should invest in equities, as their human capital comprises of a stream of income over their earning life. As agents become older, their human capital becomes depleted. Therefore older agents need to replenish their depleted human capital with fixed income securities (sukuk) in their portfolio. That is, as agents gets older, halal fixed income securities should replace equities bought during their younger periods. This is the rationale behind life-cycle funds or target-date ICs which do it automatically. 26 July

14 III. Step B (Continued) IBs offer only access to a single investment account, whose payoffs are taxed highly as current income. This account remains the same over the saver s lifecycle. In contrast, ICs offer access to tax-preferred equity funds for capital growth. In the long run, the after-tax payoffs of equity are higher (on an ex-ante basis) than that of debt contracts as illustrated in the well-known Equity Premium Puzzle (see Mehra and Prescott, 1985; Siegel, 1992). This helps savers of funds accumulate capital in the early stages of their life-cycle. For savers of funds (investors) in the later stages of their life-cycle, a hybrid facility (akin to a balanced fund) comprising of a combination (portfolio) of equity and a leasing facility offers a potentially higher payoffs on an ex-ante basis than a plain vanilla asset backed facility than an IB. 26 July

15 III. Step B (Continued) Result B: ICs can be deemed to be truly Islamic in spirit even though they do not employ any of the classic Islamic facilities. Result C: ICs have the potential of improving welfare of their constituent savers of funds on an ex-ante basis as they are more efficient (with less transaction costs) and are more flexible than IBs. Result D: If investors become aware of the potential of ICs in emerging Muslim economies, they will abandon IBs en masse leading to disintermediation. It is therefore in the best interest of policy makers in these economies to advice IBs to develop and integrate their activities with capital market (see Figure 2). This involves underwriting leasing facilities, securitizing them and developing truly Islamic money market and bond market ICs. This also involves advancing equity and balanced (hybrid) ICs. These improvements will foster long term development and stem the long divergence of these economies. 26 July

16 Figure 2. Advanced phase of financial system architecture 26 July

17 IV. Conclusion Capital market offers avenues of improving the Islamic financial architecture beyond the current retail Islamic banking emphasizing the controversial murabaha facilities. This is because it offers innovative and truly Islamic approaches to stem the economic decline of the Muslim world to revitalize growth. It will help improve the lives and the future of the Muslim Ummah. 26 July

18 IV. Conclusion (Continued) To reach the above lofty goals, efforts must be expended to structure efficient capital market instruments, institutions and markets in tune with the Shari ah. This involves joint ijtihad between finance theorist, Shari ah scholars and practitioners as advocated in Al- Alwānī (1997). 26 July

19 Contacts of the presenter Contacts of IRTI Website: Phone: +966 (0) Fax: +966 (0) P.O. BOX Jeddah Kingdom of Saudi Arabia 26 July