Islamic finance has been in the spotlight following the Global Financial Crisis of 2008, and for good reason. The market weakness revealed that Sharia-compliant financial products were generally less risky to their conventional peers and therefore tends to outperform in a downturn.
Looking deeper into this trend, we see it is mainly driven by the adoption of Islamic principles, which advocates transparency and fairness while averting excessive uncertainty. The restriction on the use of pure debt structures also reduces insolvency issues in Sharia-compliant banks and corporates. Apart from these, Islamic finance tends to benefit society through the encouragement of risk sharing and community assistance.
Restrictions bring stability
It is well known that the Sharia or Islamic Law prohibits usury (riba). But there are a few other less known prohibitions which has defined Islamic finance. Among them is uncertainty (gharar). A transaction where the buyer knows not what is being sold to him is regarded as haram or prohibited. Thus, financial products have to be clear in their offerings. Speculation (maysir) is another prohibition. Investors are not allowed to invest in a product that bears a random probabilistic outcome that is not attributable to a cause. Islam also disallows investments in prohibited industries such as those relating to gambling and alcohol.
While one may argue that restrictions in Islamic finance results in less diversity and innovation, products which have been engineered to comply with Sharia, have shown a stronger degree of stability than conventional financial products.
Evidence from the Subprime crisis
During the 2008 financial crisis, Islamic-compliant stocks were able to deliver higher returns per unit risk as compared to conventional ones. A study published in the Research Journal of Finance and Accounting found that Sharia-compliant equities in the GCC (Gulf Cooperation Council) markets markedly outperformed conventional ones in average returns during the Crisis. A big reason for the outperformance is the market preference for less risky investments. The lower leverage and less speculative business activities of Sharia-compliant corporates make them stronger fundamentally versus most non-Sharia compliant peers.
This trend is not limited to the GCC region. Between 1 June 2007 and 25 September 2008, the Dow Jones Islamic Market index, which comprise global equities, outperformed the Dow Jones World index falling 15% versus 23%, respectively.
Risk sharing does not mean higher risk
Although there is a strong emphasis on risk sharing, Islamic finance is not necessarily more risky compared with conventional finance. Several studies have proven that Sharia-compliant banks have lower credit and insolvency risk versus their conventional peers. Unlike their conventional peers, Islamic banks are generally less leveraged and restricted on how much debt they can take. They also do not engage in speculative activities, including the use of derivatives.
On the borrower side, credit risk is no different to conventional finance. However, the use of asset-based financing may improve the probability of recovery in a default. Additionally, Islam is strict about not paying back debt which should encourage the 'willingness to pay' for Muslim borrowers. In a hadith narrated by Abu Musa al-Ash’ari, the Prophet (pbuh) said: "After the grave sins which Allah has prohibited, the greatest sin is that a man dies while he has debt due from him and does not leave anything to pay it off, and meets Him with it."
What is Islamic finance?
Islamic finance is a subset of the Islamic law. It is by no means limited to Muslims only. The focus is on applying universally accepted values and ethics, such as fairness, into finance for the betterment of society.
Transparency is a key principle in Islamic finance. The Qur’an decrees that one should maximize benefits, reduce doubts and prevent dishonesty in the following verse: “And give full measure when you measure, and weigh with a straight balance. That is fair, and better at the end.” (17:35). It is widely recognized that past financial crises were in some part due to a lack of transparency in the financial system, often resulting in asset bubbles. In fact, US senator Jack Reed mentioned the following on the 2008 Subprime crisis, “The financial crisis is a stark reminder that transparency and disclosure are essential in today's marketplace.”
Finally, Islamic finance aims to contribute directly to the economic activities as Islam prohibits making money out of money without providing any degree of net benefit to the world. However, the hoarding of wealth is discouraged in Islam as well. Thus, it is better to donate money to a charitable cause or invest it such that it would lead to productive activities within the economy. It is better to channel underutilized funds to activities that benefit society.
At Kapital Boost (www.kapitalboost.com), we take Sharia-compliance seriously. We believe doing so results in a positive sum game for investors, businesses and intermediaries. As unnecessary risks are reduced, investors are better off and more inclined to participate in the financial markets. This increases the availability of funds for businesses while eventually resulting in lower financing costs. As businesses grow, employment rises therefore creating jobs and improving lives.
Kapital Boost prides itself in transparency. We reduce risks by adopting a strong disclosure policy. We carry out thorough due diligence and avoid all forms of speculative investments and unreasonable uncertainties. Our stringent requirements and significant degree of self-regulation are designed to protect investors and businesses so as to maximize net utility in society. These are done with the intention of growing the smaller players in the community – be it businesses or investors.