Let’s look at risk man faces in economic activity in general and in finance in particular. Economic prosperity and the efficiency and stability of our financial system depend on proper handling of risks. This is also true of justice and equity; they too require that risks be handled in ways favourable to building a just society.
Risk in economic activity emanates from lack of information, which in itself is often in consequence of involvement of future.
Most often one produces to sell. The longer the period of production the greater the uncertainty attaching to the selling price, generally speaking. Size of the market is also a factor. Globalisation and integration of world markets has also increased risks. Uncertainty also attaches to the cost of production. These uncertainties make the expected profits uncertain. The profits may be high or low, they may even be negative, i.e. the producer entrepreneur may sustain losses. This is the major risk a producer takes.
The producer generally runs his business by funds provided by a financier. The financier wants his/her money back and demands some reward over and above the capital invested. Such a reward can come out of the profits accruing to the producer/entrepreneur. As the return of capital as well as the reward promised is, for practical purposes, linked to the results of the enterprise, the financier too is vulnerable to the risks of business noted above.
Most often finance is provided for the entrepreneur not by the fund owner directly but by an institutional financial intermediary. The institutional financial intermediary collects investible funds from a large number of savers and supplies them to businesses that want them. Funds supplied to the intermediary are generally for short periods whereas the fund users want them for longer periods. Credit intermediation and maturity transformation, though necessary for financial intermediation, carry risks. Sometimes financial intermediaries take other risks too, like accepting funds in one currency and making investments in another currency. But these risks, like the risks taken by producers, are worth taking as they bring great benefits to society by making possible production that is large scale and takes long periods of time.
Expansion of the real economy by larger production of goods and services requires expansion of the financial sector through greater mobilisation of society’s savings and innovative methods of financing productive enterprises, exchange and distribution. With the expansion of the financial sector come more risks.
If each economic agent was left to bear the risks involved in his/her economic activity alone, economic activity will be severely constrained. It is socially advantageous to allow economic agents to distribute the burden of risk bearing among themselves. The more widespread the dispersal of risks, the larger the volume of risks that can be borne by the society as a whole, hence the more efficient the system. But this must be done equitably. Fairness requires that those who bear losses in case there are losses also get profits in case there are profits insofar as these losses/profits devolve on uncertainty. When risks are distributed in a manner that makes one category of economic agents more vulnerable to losses and another category of people more likely to gain in cases of profits, that particular scheme of distributing risks becomes anti-social.
If we allow speculators to buy risks using other people’s money (promising the ‘insured’ return of their capital with interest) the incidence of losses, in case of heavy losses, falls mainly on these other people whose money was behind the bet. Whereas their ‘profits’ are confined to the fixed fees paid by the sellers of risk. Meanwhile the intermediaries earn their commissions from profits but pass on the entire loss to the fund owners. This seems to be what happened in case of Collateralised Debt Obligations (CDOs) and Credit Default Swaps (CDSs) in the US financial market recently. It seems prudent to confine the distribution of risk among those actually involved in production, exchange and distribution of goods and services and those willing to invest their savings in these enterprises.
In other words, prudent risk distribution should exclude gamblers who want to bet on the possible outcomes of risky ventures. These bet makers do not supply more investible funds to the real sector. The funds at their disposal are used in the manner money is used in a casino: making a bet in expectation of a win, ready to lose the amount involved in the bet, with the crucial difference that the money lost belongs to other people!
RISK SHARING VERSUS RISK TRANSFERRING
If the financier agrees to a share of the profits as his/her reward, we describe this arrangement as risk sharing. But the producer/entrepreneur may not make any profit. In that case the financier gets only the capital back. There is no reward. Sometimes the producer/entrepreneur may sustain losses. In profit-sharing arrangements approved by Islam, these losses are borne by the financier.
In an interest-based economy as capitalist societies have, a significant part of funds is provided to the producer/entrepreneur on condition of being repaid with a reward added irrespective of the results of the enterprise, whether it is profits or losses. The risks involved in productive enterprise are borne entirely by the producer. The financier does not share the risks of the productive enterprise, even though he gets the rewards for financing from out of the profits of enterprise.
There are many variants of risk sharing. Also there are different ways of transferring risks. Sometimes risks may be transferred to third parties – who neither provide funds for production nor organise production. These are speculators who “buy” risks. In the current state of affairs they have become the dominant factors in the world of finance.
Buying risks involved in other people’s business is a speculative activity akin to gambling. The behaviour of such risk takers is very different from the behaviour of one taking risks involved in his/her own business. Their interest does not lie in mitigating risks. More often they wish enhanced risks as it expands their market opportunities and may bring them larger gains. Their interests lie in greater instability. The interests of those who buy risks to profit thereby are opposite the interests of the other parties – producers, fund owners and financial intermediaries. All three gain by stability but the buyer of risks gains by instability. Since society’s interest lies in reduced risks and increased stability the activities of speculators who buy risks to profit thereby should be regarded as anti-social.
A is the producer-entrepreneur being financed by B (using own funds or funds entrusted by others). B faces the risk that instead of getting any return on the funds advanced to A, he/she may suffer losses. Now comes X and offers to buy the risks from B. B would pay a price against which X offers to compensate any losses suffered by B in his/her arrangement with A. This is an example of risk shifting – transferring risk to a third party. I submit that this is not allowed in Islam. Even if X is doing similar arrangements with hundreds of financiers like B, the arrangement remains purely speculative. It is not based on any assessment of the productivity of the A’s ventures being financed. It is gambling. This arrangement that the likes of B are making with the likes of X to manage risk is very different from insurance. The Law of Large Numbers, the scientific basis for insurance, does not apply to business risks, as these are unique in each case.
The two ways of risk management, sharing or transferring, have different impacts on economy and society. Despite its predominance in the world today, risk management based on transferring the risk, or risk shifting, is less efficient as well as unjust and inequitable. A system of production and finance based on risk sharing will be more efficient and equitable.
The risk sharing arrangements are more efficient for two main reasons. First, allocation of investible funds is based on expected profitability (i.e., productivity) of the projects concerned, whereas in the interest based system allocation is heavily biased towards the creditworthiness of the project-sponsors, which depends on their wealth holding rather than on the expected profitability of the relevant projects. Second, a system of risk sharing encourages entrepreneurs and innovators—the dynamic people whose ideas take the economy forward. In contrast, a system that allows all risks to be transferred to entrepreneurs, guarantying the capital and a positive return to suppliers of investible funds protects and promotes the rentier class.
Financiers should not be allowed to transfer all the risks attending upon profit seeking on to the producer-entrepreneurs as this creates a pressure for accelerated growth that is deleterious for the environment.
Risk sharing results in a more equitable distribution of income and wealth. A system based on transferring all risk to entrepreneurs causes a continuous transfer of wealth from entrepreneurs to wealth owners (as the loss making enterprises are made to pay back the capital borrowed along with the interest promised out of their past wealth), adversely affecting the distribution of income and wealth, reducing social cohesion and increasing conflicts.
RISK SHARING IN ISLAMIC FINANCE
Among the earlier forms of risk sharing between the financier and the business being financed, the prominent ones are partnership (musharakah) and profit sharing (mudarabah). Partnership may involve sharing the profits or losses, as the case may be or sharing the products, as in case of muzaraáh (share-cropping).
The earliest reported form of financial intermediation in Islamic societies was al-mudarib yudarib, a person obtaining finance on profit sharing basis entering into a similar arrangement with another person. It is possible to model Islamic banking in modern times according to this formula. The deposit money received by Islamic banks on the basis of mudaraba should be advanced on the same basis (of profit-sharing) to investors who would then finance productive enterprises directly or on the basis of murabaha, ijara, salam/istisna, etc.
That would have kept financial intermediation separate from productive enterprise. Financial intermediation would be based on sharing whereas productive enterprise could avail itself of a variety of arrangements; buying cash, buying on credit, taking advances with the promise of delivering later, taking on lease, etc. They would still face business risks requiring them to manage by diversifying, forward sales, hedging, etc. As businesses focused on certain kinds of enterprises they would be better equipped to manage business risks, unlike financial intermediaries who cannot be expected to manage all kinds of business risks.
However, in actual practice of Islamic banking and finance during the last three decades mark up (murabaha), leasing (ijara) and prepaid orders (salam and istisna) were adapted as devices for financial intermediation. The banks/financial institutions did not in reality have any use for the real goods/services, as they were not involved in production or exchange. They used the funds at their disposal to acquire real goods/services [using salam, for example] to be passed on to those who needed using these goods/services against a debt obligation on their part. The net result is cash for debt.
This genre of intermediation seems ill suited to Islamic finance. The Islamic banks/financial institutions that relied on these sales based modes of financing in effect refused to share the risks of productive enterprises being financed. These risks were shifted to the enterprises themselves. These financing devices, like their counterparts in conventional finance, left a trail of debt obligations quantitatively larger than the cash initially advanced irrespective of the results of the enterprises so financed. This has the same impact on the macro economy as lending at interest. Even though sale with a mark up on purchase price, advance payments on counterparts to be delivered in future and leasing concluding into ownership are perfectly legitimate Islamic modes of doing business, when they are used for financial intermediation their macroeconomic impact is inequitable.
They favour financiers by shifting risks to the entrepreneurs. They create a constant pressure for growth (by mandating that total outputs be larger than total inputs) that is destructive of environment. In doing so they violated the spirit of Islamic finance insofar as risk management is concerned. This has led to widespread dissatisfaction among the customers as well as dissentions among the sponsors of Islamic banking and finance. It has also opened to derision the advantages claimed over conventional banking and finance by Islamic banking and finance as most of these claims are based on sharing. Now let’s amend the ways and move from debt creating sale-based modes of finance to sharing based financial intermediation.