Skin in the Game: Lessons from Islamic Finance for Western Finance

Skin in the Game: Lessons from Islamic Finance for Western Finance

comments 0

Comment

share

Share

4.5

Rate

Competition Winner patch Competition Winner

The global financial crisis shook the tenets of Western finance at its core. Six years later, the finance sector is still rummaging through the wreckage. Banks and investors continue to be confronted with the cost of their past misdeeds, with record penalties paid to regulators in Europe in the United States. The Dodd-Frank Act in the United States and the global response in the form of Basel III appear by most accounts second-class solutions in the face of a first-class crisis. The various scandals of the London Whale and others losing billions for their banks suggest that internal risk-management has not learned their lesson. Overall, the lingering impression remains of a finance sector that fiddles as Rome continues to burn.

The core threat to the financial system is as current as ever: Finance appears decoupled from its core fundamental role to intermediate capital in the real economy. Peeling away the immediate causes of the financial crisis, from subprime mortgages to shoddy modelling and misaligned incentive structures, a finance sector decoupled from the real economy will inevitably be exposed to bubbles. Perhaps more importantly, it will also be severely hampered in providing the necessary capital to finance the future needs of the global economy.

Overcoming this challenge will require looking outside the existing Western ecosystem to new (and old) approaches. Islamic finance in particular has been heralded as one such alternative ecosystem from which Western finance can learn.

Islamic finance has become a popular poster child for a moralist financial system at the service of society. Unfortunately, much of the debate has been philosophical. Idealists and romanticists see in Islamic finance the opportunity to return to an alternative view of man as a homo islamicus (or homo judaicus), guided by welfare principles, as opposed to a homo economicus, the concept of the self-interested, profit-maximising, rational agent, pioneered by Robbins and others.[1] In Islamic finance, it is assumed that informational asymmetries and other costs of credit are reduced as a result of the alignment of principles by lender and borrower (given shared values).[2] In addition, Islamic finance requires a social tax on finance, called zakat,[3] although it could also perhaps be translated into English as the Tobin Tax.

Leaving aside the practical application of a welfare tax, the philosophy quickly reaches its limits: Even if we are no homo economicus, building a financial system that appeals to the good of people is a recipe for disaster. The same is of course true in reverse, building a financial system that assumes a profit-maximising self-interested, rational agent, too, failed. Ultimately, suggesting the financial system would be better if people were better is a tautology, not a lesson.

The philosophical debates have diminished the value of practice. In some ways this is merited. It seems somewhat rich to ask for lessons from a financial system that through its rules inhibited the type of capital accumulation that ultimately would power the Western Industrial Revolution. Islamic finance had no small role to play in the economic quagmire that plagued the Middle Eastern economies since the demise of the Ottoman Empire. Why then, one might ask, should the practice in Islamic finance bear lessons for the modern Western financial system?

The answer is simple: Islamic finance has developed innovative investment processes that facilitates the efficient intermediation of capital in the economy. It is here where the Western financial system has faced its greatest challenge and where Islamic finance provides the most innovative solutions. The prohibition of interest and collateral, in the first case in the name of not exploiting the needy and the second of equally distributing entrepreneurial risk, have given rise to a financial system that ensures skin in the game.[4] Incentives associated with the mainstream investment products and practices look to finance the real economy as opposed to engaging in speculative activity.

This can be contrasted with the Western system as follows: Short-termism in the financial sector has led to a situation where private capital in its invested form has no long-term stake in the health and prosperity of the economy (even if the owners of the capital do). For the high-carbon energy sector in Europe for example, less than 10% of the loans of European banks mature after 10 years and nearly 80% mature within the next five years.[5] In 2010, Mercer found that 63% of long-only equity managers had shorter investment horizons than what they claimed to have when promoting their fund to institutional investors.[6] Self-defined ‘long-term investors’ only hold an estimated 9% of their portfolio in long-term illiquid investments.[7]

This type of short-termism has a number of rational reasons. It also has a range of irrational reasons, including incentive structures, hyperbolic discount functions, and time-inconsistent preferences, that lead to misallocation of capital from an efficiency perspective. The finance sector does not accurately capture long-term gains and risks of investing in the real economy, a decoupling that leads the finance sector to shirk its role of financing the long-term needs of the global economy. The inefficiency arises both when walking through the financial theory, e.g. time-inconsistent preferences lead to inefficient outcomes, and in practice as short-term investment decisions can only by chance be aligned with the long-term efficient deployment of capital.

Islamic finance could provide one solution to this short-termism with investment vehicles that ensure that capital takes a long-term stake in the health of an investment. One such investment vehicle are Sukuk bonds. Investors in Sukuk bonds have a common share in the underlying asset linked to the investment, which can be active (mudharabah) or passive (musyarakah).[8] Instead of repaying a principal with interest, Sukuk investors profit from the revenues associated with their assets. They are also known in Western parlance as profit-and-loss agreements, of which Islamic finance provides a range of instruments. The implication of holding a Sukuk bond is that they operate as shareholders with a much more proximate interest in the success of an investment. This also implies a more long-term interest, although this naturally depends on the structure of the bond relative to traditional bonds or short-term equity investments. There are a range of different Sukuk structures for the various investment and financing needs of projects and business. According to the Financial Times, Sukuk bonds have been an important source of long-term financing.[9]

Case in point where Islamic finance may be an interesting solution to the current challenge of financing long-term needs is energy efficiency. This is both true in terms of providing an alternative for market demand and supply.

Thus, in the case of market demand, energy efficiency projects face a number of financing barriers intrinsic to the financial system, including issues around securitization and pricing.[10] Sukuk bonds, by creating project ‘shares’, could overcome some of these barriers.

Similarly in the case of supply. It should be noted that many institutional investors have an expressed interest in long-term portfolios as a result of their long-term liabilities (e.g. life insurers, pension funds, etc.), or long-term investment mandates (e.g. most sovereign wealth funds). They have a clear interest in ‘portfolio matching’ their long-term liabilities with long-term assets. They also are increasingly looking for long-term investments that contribute to the transition to a low-carbon economy. Initiatives such as the one launched by Ceres and the Carbon Tracker Initiative, as well as the Institutional Investor Group on Climate Change are evidence to that effect Sukuk bonds could thus contribute to providing capital demand in the area of energy efficiency with options in terms of financial products, and new alternatives for the market supply.

Although the goal was to focus on practice, this practice is indeed not too foreign to Western financial systems and thus can very well grow on fertile ground. Germany has a long tradition of a variant of stakeholder banking, with banks taking an active role in the companies they invest in. Increasingly however, the stakeholder model is becoming marginalized by shareholder-types financial products and processes. Islamic finance may create a counterweight to this trend. It can contribute to rebuilding a financial system with skin in the game.

 

References: 

[1] Robbins, Lionel (1938) “Interpersonal Comparison of Utility: A Comment.” The Economic Journal 48(192). P. 635-641.

[2] Chapra, M. Umer (2000) The Future of Economics, An Islamic Perspective.  United

Kingdom: The Islamic Foundation.

[3] Ibid.

[4] Chapra, M. Umer (2006) “Why Has Islam Prohibited Interest? Rationale Behind the Prohibition of Interest”. In: Thomas, Abdulkader (ed.) Interest in Islamic Economics. London: Routledge. 

[5] Green European Foundation (GEF) (2014) “Carbon Bubble: The Price of Doing Too Little Too Late” Accessed 17.04.2014 from http://gef.eu/publication/carbon-bubble-the-price-of-doing-too-little-too-late/.

[6] Mercer (2010) „Investment Horizons: Do Managers Do What They Say?“ Accessed 30.06.2014 from http://www.irrcinstitute.org/pdf/IRRCMercerInvestmentHorizonsReport_Feb2010.pdf

[7] World Economic Forum (WEF) (2012) “Measurement, Governance and Long-Term Investing”. Accessed 17.04.2014 from http://www3.weforum.org/docs/WEF_IV_MeasurementGovernanceLongtermInvesting_Report_2012.pdf.

[8] Aggarwal, R.K. and T. Yousef (1996) Islamic Banks and Investment Finance. Social Science Research Network.

[9] Fincancial Times (2014) „Sukuk Bonds“. Accessed 30.06.2014 from http://lexicon.ft.com/term?term=sukuk-(Islamic-bonds).

[10] IEA (2007) “Mind the Gap: Quantifying Principal-Agent Problems in Energy Efficiency”. IEA Paper in support of the G8 Action Plan. Accessed 18.05.2014 from http://www.iea.org/publications/freepublications/publication/mind_the_gap.pdf.

There are 0 comments