Part of the recommendation from the Turner Report on regulating the UK banking sector was to look at the substance of a transaction rather than its legal form. It acknowledges that whereas banks are offering products that follow the law, the effects of the products might be detrimental to the world economy – the externality problem. In economic parlance, externality has usually referred to the consequences of commercial transactions, such as pollution. It was only until the financial crisis that regulators realised the consequences of financial failure could have a massive impact on society. The contagion effects were huge.
An acceptance of externalities of financial products leaves regulators scratching their heads. They are placed in a paradox: on the one hand banks are similar to any other profit making institutions and the sought after high returns are concomitant to undertaking risky positions, but if you restrict banks ability to profit due to fears that the risks might have a possible wider social impact, then banks – the oil that makes the economic machine work – will be left weakened and impotent.
It is this conundrum that leaves regulators seesawing between criticism and praise. Banks are indispensible to the running of the economy but in propelling the economy, banks, by their current nature, simply build more debt. The substance of today’s economy is debt. And only through debt can you increase, exponentially, the money supply. Increased money means that more companies can be funded.
The system works until there is a widespread demand for initial deposits or for repayment of loans as occurred with the financial crisis. The wheels fell off, but why it came a surprise to so many is beyond belief. The risk of debt default is high when there is so much debt, and good times cannot last for everyone all the time.
Islamic financial products are predominately debt products. This is not so evident given the legal structures of products requires ownership of assets and typically some sort of buy and sell back regime whether it be a murabaha, ijara, or salam structure that is being extensively used. Sukuks are usually known as Islamic bonds, and in substance there is much similarity to a conventional structured bond. Proponents would argue the legal differences are substantial, which is true, but if the bottom line is one party owes another party money at a certain time, then we have a situation of debt.
In sukuk contracts there is usually collateral, and a gurantor, which can comfort investors. But once again these are facets of a debt contract. So, if the proliferation of products that are substantially debt based, then can we predict that sometime in the near future it is going to bottom out and the Islamic financial industry will suffer its own crisis? I think we can.
The solution would be partnership products – musharaka and mudaraba – where the investor shares in the risk and the profits of the invested project. The problem that occurs is in a debt contract in today’s financial system, banks provide funds with deposits backing up the disbursement. You cannot do that with partnership contracts. The investor knows how much he has put for investment. This reduces the pool from which banks can invest, meaning there is less investment into commercial activity, meaning less country growth.
The Islamic proponent now understands the headache of the British regulator. Countries are dedicated to economic growth and bank funds allow it to occur. To push for greater GDP, with more commercial products in the market to meet the needs of a greater population, you need high amount of funds. The Middle Eastern countries can do this well given the oil revenue but with increased depletion of oil, the good times will not last. Boosting the financial markets, which we see in Qatar, Saudi Arabia, UAE, Kuwait and Oman, can help in transferring focus. .
So the toss up becomes less economic growth, less commercial activity, less debt; or more economic growth, more commercial activity, but more debt. Most will opt for the latter because periods of downturn will be met with the good times eventually. It is a sacrifice policy makers and financiers are willing to accept, because it is just assumed that higher economic growth means a greater spread of wealth. Concerns, however, should be towards the greater usage of resources that are leading to higher prices, environmental destruction and disparity. Wealth is increasing but it is narrowing into the hands of a few.
Nonetheless it is unlikely one will see a change in the financial system given the focus on GDP. And it is unlikely Islamic finance will initiate a change of thinking as most products are debt based products. Perhaps that is why the West is so interested in the Islamic financial industry. There is more chance for multiplier effects using debt based products than equity. If the Islamic finance industry pushed more partnership products, it is unlikely they would be too keen.