Derivatives are Financial Weapon of Mass Destruction

Assalamualaikum,

Dear Readers,

“Derivatives are Financial Weapon of Mass Destruction” Warren Buffet. Click Here

Generally, Shari’ah scholars have discussed almost all major areas of Islamic banking and finance and provide variety of instruments as alternative to the conventional counterpart except derivatives, short selling and speculations in the foreign exchange markets. There must be a cogent reason behind this position. Perhaps, the recent economic crisis may enlighten the issue of why Shari’ah prohibits element of excessive gharar, speculation and interest in any kind of business transaction.

I attach herewith a simple and concise but very informative and illuminating article by Mansoor Durrani where he tries to explain the current phenomenal of economic crisis. For full article Click Here

Best Regard
ZULKIFLI HASAN
DURHAM UNIVERSITY

Trafalgar Square, London

STAKEHOLDERS MODEL OF GOVERNANCE IN ISLAMIC ECONOMIC SYSTEM: REVISIT

This paper has been presented for Finance, Business and Economic Discussion Group of School of Government and International Affairs, Durham University. (Copyright 2008)
For full article in PDF, Click Here

ABSTRACT

Corporate governance is one of the essential elements of any corporation development as it plays roles to design and promote principles of fairness, accountability and transparency. Western concept of corporate governance either the Anglo-American model that promotes shareholder-value system or the European Model that upholds the stakeholder-value system has been subject of continuing debate for well over a century. By contrast, it is observed that there is not much discussion or literature on the issue of corporate governance from the Islamic perspective. Due to the lack of literatures, Iqbal and Mirakhor attempts to formulate Islamic corporate governance which is based on stakeholder-oriented model. Their main arguments are founded on two fundamental concepts of Islamic law i.e. property rights and principles of contract. This deconstruction paper is intended to provide brief analysis and commentaries on the issue of corporate governance in Islamic economic system.

1.0 Introduction

Corporate governance in banking has been analyzed very extensively in the context of conventional banking markets. By contrast, little is written on corporate governance from Islamic perspective particularly the governance structures of Islamic finance sector, despite its rapid growth since the mid 1970s and their increasing presence on world financial markets (Hamid, Y. (2007: 308).

Only in 1990s there are few international infrastructure institutions established with purpose to support the Islamic financial sector particularly on the issue of corporate governance and these include the Accounting and Auditing Organization for Islamic Financial Institution (AAOIFI) and the Islamic Financial Services Board (IFSB). The AAOIFI has issued 56 standards and 4 of them are specifically related with the shari’ah corporate governance namely the standard on Shari’ah Supervisory Board: Appointment, Composition and Report, Shari’ah Review, Internal Shari’ah Review and Audit and Governance Committee for Islamic Financial Institutions (Iqbal. M, 2007: 373). The IFSB has issued a few prudential standards on Capital Adequacy, Governance of Investment Funds, and Corporate Governance in Takaful Operations, Shari’ah Governance and Market Conduct. There are few standards which specifically providing guidelines on corporate governance namely the Guiding Principles of Risk Management for Institutions (other than Insurance Institutions) offering only Islamic Financial Services (GPCG) issued in December 2005 and the Guiding Principles On Corporate Governance For Institutions Offering Only Islamic Financial Services (Excluding Islamic Insurance (Takaful) Institutions And Islamic Mutual Funds) issued in December 2006 (IFSB, 2008).

In the context of theoretical framework of Islamic corporate governance, there are a few studies have been carried out particularly Islamic financial institutions to come up with alternative models of corporate governance. Iqbal, Z, and Mirakhor, A, in their paper seem to suggest that the Stakeholder-oriented model of corporate governance finds its strong roots in Islamic economic system.

2.0 The Basic Idea of the Paper

2.1 As pointed out by the author, there are significant problem with the Anglo-Saxon model of corporate governance commonly referred as agency problems. In fact, the business ethicists have considered the shareholder model to be unethical and unacceptable because it neglects the right of non-shareholders and other stakeholders.

2.2 The neo-institutional economists formulate a stakeholder theory of corporate governance and argue that the corporation’s claimants go beyond shareholders and to include others with whom it has any explicit and implicit contractual interaction. The Stakeholder theory rejects the three main propositions of the Shareholder model namely all stakeholders have a right to participate in corporate decisions that affect them, manager’s fiduciary duty to protect the interest of all stakeholder and the corporation’s objective to promote the interest of stakeholder and not only shareholders.

2.3 A critical review of the literatures on the concept of Stakeholder model suggests that there are a lot discrepancy of arguments, contradictory evidence and lack of formal analysis. For instance, the stakeholder theory is unable to resolve the issue of the determination of who really qualifies as an actual stakeholder and whether all the stakeholders should be given rights to influence management decision-making? The authors argue that the stakeholder model have not been able to convince on theoretical, moral or legal grounds that the stakeholders should play an active role in management and control of firm.

2.4 By contrast, the authors view that the stakeholder-oriented theory of corporate governance is strongly recognized in Islam via two fundamental concepts pertaining to property rights and principles of contracts. A major part of discussion attempts to clarify the concept of property rights in Islam and the rest on the principles of contracts as well as corporate governance structure. The authors conclude the paper by emphasizing that the corporation’s objective should be to maximize the welfare of all stakeholders. They further argue that Islam provides strong theoretical foundation to acknowledge the rights and interest of all stakeholders via the principles of property rights and contracts. The governance of any corporation in Islam is ruled by Shari’ah where all the stakeholders including the shareholders, the management, other stakeholders such as the employees, the suppliers, the depositors and the community. The Shari’ah board plays a role to advise and supervise the operation of the corporation so as to ensure that it complies with the Shari’ah principles. The board of directors acting on behalf of the shareholders has duty to monitor and oversee overall business activities and the managers have fiduciary duty to manage the firm as a trust for all the stakeholders and not for the shareholders alone. The other stakeholders such as employees, depositors, customers have duty to perform all of their contractual obligations. In addition, the state as a stakeholder will be the external institution to provide regulatory framework and its enforcement. The definition of stakeholders does not necessary refer to the shareholders per se or to those who have active participation in the decision making process but it includes non-investor or non-owner stakeholders i.e. any party who has direct or indirect participation in the corporation.

3.0 Commentaries

3.1 It is worth to mention that there are other papers on the issue of corporate governance model in Islamic economic system. Chapra, M.U. and Ahmed, H, (2002: 13-20) in their research on corporate governance of Islamic financial institution emphasize on the notion of equitably protecting the rights of all stakeholders irrespective of whether they hold equity or not. In addition, Nienhaus, V., (2003: 290) states that Islamic corporate governance should be based on value oriented and promote the principle of fairness and justice with respect to all stakeholders . Archer, S. and Rifaat, A.A.K. (2007) impliedly view that the corporate governance of Islamic financial institution is inclined toward the stakeholders value based model. This is because the nature of corporation particularly of the directors and the management owe fiduciary duties of care and loyalty to the shareholders and also other stakeholders including especially the investment account holders. Grais, W and Pellegrini, M., (2006) view that corporate governance of Islamic financial sector concerns with the issue of protecting the stakeholders’ financial interests via internal and external arrangements. Wajdi, A.D. (2008: 391-413) further supports the notion of stakeholder oriented model in Islamic financial sector where he provides the pyramid of maslahah as a devise or mechanism to protect rights and interests of various stakeholders. Choudury, M,A. and Hoque, M. Z, (2004) on the other hand provide an epistemological aspect of corporate governance by formulating corporate governance approach based on the principle of consultation where all stakeholders share the same goal of Tawhid or the oneness of Allah. Unlike the five papers, Iqbal, Z and Mirakhor, A, attempt to provide theoretical foundations of the Islamic corporate governance through two fundamental Islamic principles of property rights and contracts.

3.2 Generally, the overall presentation of the paper is theoretical in nature. The paper clearly provides the Islamic concept of corporate governance which is founded on the principles of property rights and contracts. The authors argue that the Stakeholder theory of corporate governance is strongly recognized in Islam and therefore acknowledging the rights and interest of all stakeholders to participate in corporate decisions.

3.3 In term of literature review on the conventional literatures on the stakeholder model of corporate governance, the authors rely on a very few studies which are too brief and lack of empirical evidence. The paper does not provide basic features and characteristics of the Stakeholder model that may useful to differentiate with the Islamic concept of corporate governance in the rest of the paper.

3.4 In the aspect of jurisprudential analysis, the authors justify their arguments by providing evidence mainly from primary sources of al-Quran and al-Sunnah and the legal maxim. There seems to be lack of discussion on certain issue such as the elaboration on the Islamic conception of justice or al-adl wa al-ihsan. In addition, the authors do not provide any legal evidence on their definition of corporation. It is contended that that there is less discussion by Muslim scholars on a concept akin to the corporation . In fact, Kuran, T., (2005) writes that the corporation was absent from the Middle East until the nineteenth century . The authors may explain the concept of corporation to develop the notion of acknowledging the rights and interest of all stakeholders in the firm.

3.5 Chapra, M.U in his critical review on the paper commented that while the paper is positively supported the stakeholder model and acknowledge the stakeholders rights, it does not show how to ensure that these rights are protected. The authors’ argument that the observance of rules of behavior guarantees internalization of stakeholder rights seems difficult to be materialized. Chapra, M.U. argues that Islamic norms had become internalized in the Muslim society in classical period of Islamic society and it does not work in today’s society. There are few factors that contributed to the phenomenon of internalization of the stakeholders’ rights and they include common practice of Islamic values, nature of communities, economic environment, absence of agency problems, extensive legal instrument for trade and independence of judiciary (Chapra, M. Umer, 2007: 329-330). In this aspect, he views that there are other factors need for the internalization of stakeholder rights such as well- functioning competitive markets and proper legal framework for the protection of stakeholders.

3.6 Another debatable argument refers to the authors’ view that the task of designing of a corporate governance system is solely the prerogative of the Islamic government. It is the duty of Islamic government to regulate the rules and legislation to specify the appropriate corporate governance structure. This argument raises a few issues such as question on what is Islamic government and how to design the corporate governance structure of Islamic corporation in the countries where the Muslims are minorities. This point needs to be revisited or supported with other cogent arguments.

3.7 The authors view that the institutional arrangement as part of the governance structure is very important in order to provide protection to all stakeholders and to mediate where disputes arise. Interestingly, the paper considers a Shari’ah board as a unique institutional arrangement in Islamic corporate governance whereby it plays a role to oversea and supervises the Shari’ah aspects of Islamic corporation’s activities. The authors further express their views that the idea of Shari’ah board could be extended to a system level board consisting of scholars from various disciplines of economics, finance, shari’ah, management and commercial law. The paper however does not discuss other essential institutional arrangements in Islamic corporation such as the shareholders and the depositors in the case of Islamic financial institutions, the management and the board of directors.

3.8 The overall arguments of the paper provide theoretical foundation of the Stakeholder model of corporate governance in Islamic economic system where the firm’s objective is to maximize the welfare of all stakeholders. It is observed however in a few researches, the main objective of the corporation including the so called Islamic corporation is to maximize the shareholder’s value of wealth. This implies that in actual practice, many Islamic corporations adopt the Shareholder model of corporate governance rather than the Stakeholder model . Therefore, the issue before researchers and scholars is to come up not only with theoretical foundations of Islamic corporate governance but to support it with empirical evidence and appropriate case studies as to the actual corporate governance practice and possible transformation.

4.0 Conclusion

The model of corporate governance system in Western perspective either the Shareholder or the Stakeholder models raises an issue of the design of an efficient corporate governance structure in Islamic economic system. Iqbal, Z, and Mirakhor, A, come up with an approach that the Islamic corporate governance inclines toward the stakeholder-oriented model where its governance style aims at protecting the rights and interest of all stakeholders as a whole. They provide theoretical foundations of the Islamic corporate governance through two fundamental principles of property rights and contracts. While the paper presents convincing arguments on the stakeholders’ model of governance from Islamic perspective, there are several debatable points that need to be further explored and discussed. A critical review of the paper seems to suggest that there is a need for further research on the issue of corporate governance in Islamic economic system from theoretical and empirical perspectives.

Best Regard
ZULKIFLI HASAN
DURHAM UNIVERSITY

International Awqaf Conference, South Africa.

Why short-selling is Haram

Quoted from the AME Info. http://www.ameinfo.com/170733.html

Amid the financial crisis, the US stock market regulator SEC banned short selling on September 24, but it aims to lift this ban on Thursday, October 9. In Islamic Finance, however, ‘to go short’ will always be Haram.

In order to protect the stock markets from sliding further the Securities and Exchange Commission (SEC) saw no way out other than banning short-selling. After the enactment of a $700bn rescue package for Wall Street, the SEC, however, announced that the ban would be lifted on Wednesday, at 23.59. Short selling occurs when stock market participants sell stocks or commodities they do not own in order to profit later from an anticipated fall in prices. It is a strategy widely used by hedge funds, which often are blamed for contributing to the fall of market instruments.

Shariah against short-selling. Because of the latter phenomenon, short selling is considered as haram under Shariah. ‘In Islamic Finance, we deny the conventional way of thinking, which aims of creating a new dollar out of every dollar’, says renowned Pakistani Shariah scholar Sheikh Dr. Taqi Usmani. By selling a stock short, the ‘investor’ may gain while the underlying company loses value – a clear violation of the ban of unjust deeds, stated in the Holy Quran, Sure Al Baqara, 2, 278 – 279: ‘Deal not unjustly, and ye shall not be dealt unjustly’. Islamic Finance is about serving society. By selling a stock short, an avalanche of more short-sellers might be triggered, leading the firm to expensive stock buy-back initiatives or in the worst case to bankruptcy. As well as short selling, day trading is labelled as speculation and therefore is counted as haram as well. Market participants are certainly allowed to profit, but this should add value to the entire economic system.

Shariah banking’s moral stance. The aspect of Tauhid, or unity, is also core in Islamic Finance. It is not only about investing in ‘pure’ stocks or avoiding interest. It is about protecting society from trickery, fraud and social tensions. Furthermore, Shariah banking bans sector which allegedly hurt Muslim society and family values as well.Sectors which are unacceptable or haram under Islamic Law (Shariah) are well-known. An Islamic Fund manager is not allowed to invest in stocks pertaining to alcohol, tobacco, pornography, entertainment, defense and the conventional banking and insurance sector.

With the temporary ban of short-selling, Western financial regulators adapted for the first time a core principle of Islamic Finance. Will they now look at the Quran more closely in order to avoid another Black Monday? Remember, most Islamic Banks in the GCC have so far achieved double-digit gains in 2008 while conventional banks currently recount their biggest losses in history.

Best Regard
ZULKIFLI HASAN

Global Conference on Business and Finance, South Padre Island, Texas, USA

Is Islamic finance at tipping point?

Quoted from the Economist By Christopher Watts

In January this year when the UAE’s Sharjah Electricity and Water Authority (SEWA) needed cash to construct a power generation and desalination plant in the town of Hamriyah, it was Islamic finance that provided the answer: The utility raised USD 350 m by issuing its first ever sukuk – asset-backed bonds that comply with Shari’a, the Islamic legal code that prohibits interest.By no means is SEWA alone in venturing into the Islamic capital markets. Corporate sukuk issuance leapt from USD 0.4 billion in 2000 to USD 24.5 billion in 2006, according to International Islamic Financial Market (IIFM), an industry association. Growth topped 122% in 2006 alone. “Islamic finance is no longer a niche market,” says David Pace, CFO of Bahrain-based Unicorn Investment Bank (UIB), a Shari’a-compliant house. “It is increasingly a mainstream component of the global banking system.”

To be sure, while the world’s first Islamic bank was founded back in 1975, it is only in the last five years or so that Islamic finance has surged. Sniffing opportunity, conventional banks are now scrambling to set up Shari’a-compliant operations; and there has been a flurry of all-Islamic start-ups, from full-service investment banks to specialist advisory firms. Products have moved beyond lending, insurance and investment funds to include sukuk, hedge funds, currency swaps, and more.

Despite this boom – largely concentrated in the Middle East and South-East Asia – it’s plain the Islamic finance industry still lacks global scale. Professor Rodney Wilson of the Institute for Middle Eastern and Islamic studies at Durham University in the UK estimates Islamic banking assets speak for less than 0.5% of the world’s total. And worldwide sukuk debt outstanding amounts to perhaps USD 100 billion – just 0.1% of the global bond market. Still, the signs point to a continuing surge in Islamic finance. Take economic growth: The Middle East and Asia are the two fastest-growing areas of the world. Kuwait Finance House expects 2007 GDP to rise 6.1% in the GCC and 6.2% in South-East Asia – in contrast to 2.4% in the EU and 2.2% in the US. Oil revenues lie behind the boom in the GCC; and in South-East Asia it is “the financial rigour adopted in the wake of the Asian currency crises,” according to Douglas Clark Johnson, CEO of Calyx Financial, an alternative investment adviser based in New York.

Continuing growth in the GCC states and South-East Asia is fast creating a prosperous middle class among the regions’ combined 410 m-strong Muslim population. As the ranks of the regions’ newly well-off snap up credit to buy homes and cars, and invest in savings and retirement plans, demand for Shari’a-compliant retail financial services is set to accelerate. Behind such consumer products is a need for Islamic institutional finance too.

Consider, too, the vast cash-flows into the GCC region and South-East Asia: The IMF expects Indonesia and Malaysia alone to record a cumulative current account surplus of USD 132 billion for the five-year period to end-2008, in contrast to a deficit of USD 32 billion for the same period a decade earlier. And in the GCC, the surplus should reach USD 680 billion, versus a prior deficit of USD 8 billion.

Buoyed by this cash, regional governments are planning ambitious infrastructure programmes: Indonesia alone expects USD 110 billion of expenditure in the five years to end-2010; and consulting firm McKinsey estimates the GCC will invest USD 200 billion in the same period. Much of this spending is already being financed by sukuk – and the volume is set to balloon: Following its successful sukuk issue, SEWA hopes to raise another USD 2.7 billion. And in neighbouring Dubai, the electricity and water authority is eyeing a debut sukuk issue, with plans to raise USD 2.5 billion.

With ever-stronger foundations in the Middle East and Asia, Islamic finance is now starting to take hold in London, too. The UK’s first standalone Shari’a-compliant bank opened its doors in 2004; two others have followed; another is on the way. (All are backed by Middle Eastern institutions.) And in April this year the London Stock Exchange listed its maiden sukuk, adding much-needed depth and liquidity to the market. Another milestone is in sight: the UK government is mulling its first sovereign sukuk issue, perhaps as soon as early-2008.

But challenges remain. If Islamic finance is to move deeper into mainstream global finance, the industry needs to improve transparency and foster credibility by harmonising standards and practices. Not least, Shari’a interpretation varies between regions and even institutions. Regulatory oversight need to be sharpened as well. These measures – and others – could be critical in broadening the appeal of Islamic finance and bridging the gap between Islamic and conventional financial systems.

The Islamic finance industry needs to work on innovation, too. Shari’s-compliant products can be more complex than conventional ones because every transaction is backed a non-financial trade. Many instruments are still lacking, including corporate treasury and derivatives products. As UIB’s Pace points out: “We [in the industry] need to change our perception of R&D, and view it as a core ingredient of success.” But at the same time, innovation is hampered by the limited number of Islamic scholars able to vet financial products for Shari’a compliance.

For certain, industry practitioners are making progress. Earlier this year the International Capital Market Association and the IIFM agreed to develop standard contracts and common best practice for secondary trading of sukuk and other Islamic instruments. And it may help, too, that global banking giants are putting their weight behind Islamic finance. (Deutsche Bank, Barclays Capital and BNP Paribas are already among the world’s top five issuers of sukuk.) The question whether Islamic finance has reached critical mass remains open, of course. But Johnson of Calyx Financial is optimistic: “The tipping point may already have arrived,” he ventures. Even if Johnson is wrong in his optimism, it seems unlikely history will prove him to have been very far wide of the mark.

Best Regard
ZULKIFLI HASAN
DURHAM UNIVERSITY

International Conference on Endowment’s Investment, Dubai.

Malaysian Financial System Can Weather Current Global Financial Turmoil

Quoted from http://www.bnm.gov.my/index.php?ch=8&pg=14&ac=1701

Despite the increased volatility in the global financial markets, Malaysian financial institutions remain resilient . Several years of reforms, institutional development and capacity building, continuous efforts to enhance corporate governance and risk management standards and practices have significantly strengthened the banking system. The level of non-performing loans has also improved to 2.5%. In addition, the standardised approach of the Basel II capital adequacy framework was implemented effective January 2008. There is also ample liquidity in Malaysia ‘s financial system to facilitate the orderly functioning of economic and financing activities. As at end-August 2008, net interbank placements with Bank Negara Malaysia by the banking system amounted to RM198.5 billion.

The banking and insurance industries are therefore operating with adequate capital and liquidity buffers that have been accumulated over several years. Malaysia ‘s financial institutions also have negligible exposure to both sub-prime related securities and to the affected financial institutions of other countries, with more than 90% of total assets of the banks and insurance companies in ringgit denominated assets. In addition, all foreign financial institutions in Malaysia are locally incorporated and have a high level of capital that is committed to support their domestic operations. As at end-August 2008, the risk-weighted capital ratio for these foreign financial institutions was at 12.6%.

The banking system’s leverage position remains manageable and continues to record strong risk-weighted capital ratio of 13.2% as at end-August 2008, exceeding the minimum 8% capital requirement by RM42.3 billion. The insurance industry also recorded high solvency surplus of RM16.5 billion. The strong capital position combined with ample liquidity provides adequate capacity to the banking system to continue to perform its intermediation function and to meet its financial commitments as well as the demands for financing and financial services in supporting domestic economic activities. The aggregate domestic household sector continues to exhibit stable level of indebtedness and wealth where total financial assets are more than two times of total debts. Overall, corporations also continue to exhibit sound financial position and manageable leverage position with debt-to-equity ratio of 48% in the first half of 2008.

The Central Bank has a fully developed supervisory and surveillance system. It continuously monitors all financial institutions under its purview and will take appropriate action to safeguard the soundness of the financial system. The Bank stands ready to provide liquidity, whenever necessary, to financial institutions under its purview. The Bank is also closely engaging with the other monetary authorities in the region to monitor and respond with co-ordinated measures in managing the current challenging environment.

Best Regard
ZULKIFLI HASAN
DURHAM UNIVERSITY

Times Square, New York.