Role of Islamic banks in secondary financial markets

A pressing challenge is the lack of liquid and active secondary sukuk markets in key Islamic finance domiciles

By AKBAR KOMIJANI & FARHAD TAGHIZADEH-HESARY / Pic By TMR

The development of secondary financial markets is vital for the expansion of primary markets. Savers have different preferences with regard to the liquidity and risk of their portfolios. The faster savers can liquidate or transform their assets and the fewer the risks involved, the more likely they are to hold long-term securities.

When Islamic banks are able to issue various securities with either certain or uncertain returns to finance real economic activities, investors will show a greater interest in Islamic financial products when the security markets are sound and well developed.

Islamic bonds traded along with conventional papers, such as stocks and options, in the financial markets help Islamic banks to diversify and distribute risk and manage the liquidity of their portfolios. Moreover, as Islamic banks are necessarily involved in financing and investment in the real economy, the existence of commodity markets may assist the transparency and reduction of costs for Islamic banks and improve the efficiency of Islamic financing systems (Mirakhor 1992).

A pressing challenge is the lack of liquid and active secondary sukuk markets in key Islamic finance domiciles, which limits investors’ ability to trade sukuk instruments.

To date, in Asia, only Malaysia and Iran have a fully functioning Islamic money market with an active secondary market that is very effective in addressing the domestic Islamic financial market’s liquidity management issues (Islamic Financial Services Board 2015).

Prohibition of Riba

The prohibition of riba results in the immediate disappearance of bonds and the debt market in an Islamic economic system. Most jurists believe that debt instruments, such as bonds for which the issuer guarantees the nominal value, are not tradable in an Islamic market, even though interest may be absent.

The main reason behind the prohibition of conventional debt and bond markets in Islam is the notion of ownership in conventional bonds.

Bonds are securities in the form of debt; however, sukuk indicates ownership of an asset (ie, an infrastructural project). Sukuk can increase in value when the assets increase in value, but there is the possibility of a decrease in value. The sale of sukuk is the sale of the ownership of the assets backing them, whereas the sale of bonds is the sale of debt.

Except for participation contracts, the assets of an Islamic financial intermediary are connected to other assets. This basket of assets has interesting features.

First, it includes a vast range of maturities from short-term business finance to mid-term rent contracts. Second, these assets have low risks, since their yields are directly related to predetermined cashflows. Finally, predetermined cashflows and fixed maturities make these securities suitable alternatives for conventional fixed-return bonds. Such securities will also be attractive in conventional financial systems.

Recent developments in mortgage-based securities in conventional financial markets show that a dynamic and efficient market can develop on the basis of real assets. In essence, an asset-based security market has replaced the debt market in an Islamic financial system. This market assumes a vital role by providing liquidity for the financial system.

Financial derivatives construct the second important market. Muslim jurists have so far been of the opinion that conventional derivatives include the element of gharar (ambiguous deal) and therefore are prohibited in Shariah.

Gharar means the ambiguity and ignorance that prevail with regard to the price and delivery time of the assets that back derivatives such as forwards, futures, options and swaps. However, some financial derivatives, such as futures and options for the subordinate sale of shares — which insure shares against price reductions, have gained permission from jurists for trading in the Iranian capital market.

In asset pricing, the representation of lender payoffs under put-call parity permits the identification and exact valuation of all the constituent components of asset-based Islamic finance as balance sheet identities within the standard Black-Scholes-Merton framework of capital structure-based option pricing theory (Black and Scholes 1973; Merton 1973, 1974).

Jobst (2007) showed how to derive the fair market price of Islamic lending transactions if the underlying collateral conforms to a lognormal asset process. In particular, Jobst characterised the implicit interest rate of Islamic lending as a result of the premium payments (ie, periodic rental payments) that the lender receives in return for the call position on assets that the borrower holds in Islamic finance.

The role of financial intermediation and the dependency of an Islamic financial system on Islamic banks are clear. They are also in line with the empirical evidence that highlights the role of financial intermediaries in less-developed capital markets.

In a nutshell, an Islamic financial system will be similar to a bank-based one for the following reasons:

(a) Due to the prohibition of riba and debt papers, the debt-based capital market will be non-existent. Therefore, financial intermediation will take the form of direct financing via Mudarabah and participation contracts.

(b) In the absence of a debt market, there will be a demand for the development of asset-based security markets to increase the liquidity of bank assets. Financial intermediation can play a vital role in this development via the introduction and accumulation of financial instruments through the securitisation and enhancement of credit during the life cycle of assets.

(c) Since risk-shifting violates the basic principles of Shariah law, derivatives remain controversial in Islamic finance. In particular, Shariah scholars still do not readily accept derivative trading due to its often speculative and unfunded nature (Jobst and Solé 2009). The unavailability or restriction of the derivative market will increase the pressure on financial intermediaries to offer sharing and mitigation of risks.

Outlook

The Islamic finance industry has grown substantially in Asia over the two last decades. We can expect the growth of Islamic banking and finance to continue, with the following underpinning factors:

(i) The Muslim populations in different Asian countries, especially in South-East Asia, are increasing. Rapid Muslim population growth and improving living standards may enhance the popularity of Islamic finance as a keen alternative to conventional financing mechanisms.

In addition, investors from the Middle East and Asia are increasingly seeking to invest in products that are in line with their religious beliefs. Surveys have suggested that half of the Muslims worldwide would opt for Islamic finance if given a reliable alternative to conventional services (KFHR 2013).

(ii) The governments and financial authorities in several Asian countries have played active roles in promoting the development of Islamic financial markets in line with the efforts to boost investments and achieve sustainable funding to enhance economic growth by tapping the huge liquidity from oil- and commodity-producing countries.

(iii) The ethical character and financial stability of Islamic financial products may increase their attraction. Islamic financial products have an ethical focus (notably excluding investment in alcohol and gambling) with a risk profile that appeals to wider ethically conscious investors. Islamic finance has been put forward as a viable alternative financial system (KFHR 2013).

(iv) Given that, in Islamic banking, returns on investments are based on underlying economic activities and/or assets that structure the contractual relationship between transacting parties, it is possible to use the asset-based nature and risk-sharing aspects of Islamic finance for greater integration with the real economy and to improve the overall economic balance between the real and the finance sector.

Overall, the outlook for Islamic banking and finance in Asia is bright, given that the region is home to more than 60% of the world’s Muslim population, as well as Asia’s growing middle class, and has strong economic and financial fundamentals. In addition, a combination of strong political support, a large investor base, and generous tax incentives are enticements to further Islamic finance in Asia.

  • Extracted from the Asian Development Bank Institute report entitled ‘An Overview of Islamic Banking and Finance in Asia’. Akbar Komijani is professor of economics at the University of Tehran, while Farhad Taghizadeh-Hesary is assistant professor of economics at the Faculty of Political Science and Economics of Waseda University in Tokyo.

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