‘Risk Management Should Be Done Before The Crisis, Not After

KUWAIT CITY, Feb 7: “Islamic banking has become an alternative to conventional banking after the recent crisis. There appears to be a great potential for growth in the industry. There are challenges associated with developing an industry with a different approach to “risk management.” However, this can be the best time to grow the Islamic financial market, since Basel III can be an opportunity rather than an obstacle. Because in terms of capital adequacy, Islamic banking is already placed well,” stated Dr. Yildiray Yildirim, Associate Professor of Finance, Chair, Finance Department, Whitman School of Management at the Syracuse University in New York, during a lecture on Wednesday evening at the Kuwait Economic Society.

The lecture entitled “Recent Financial Crisis and opportunities of Islamic Finance, organised by the Kuwait Economic Society tackled the simple comparison between conventional and Islamic finance in the context of the financial crisis, challenges, risk management, importance of securitization, what went wrong, how could it be prevented, the current market conditions and the opportunities in Islamic finance.

Dr Yildirim explained that in conventional setting, securitization led mortgage lenders trading excessive risk (gharar). Historically, banks kept on their books the loans they originated. However, he pointed out that over time, they move away from originate-to-hold model with the originate-to-distribute model by selling them in the secondary loan market (structured finance). Corporate loan securitization allowed banks to sell loans off their balance sheets — particularly riskier loans, which have been traditionally more difficult to syndicate.

He cited that in the primary market, the loans are originated and charged with interest (riba). In conventional case, securitized products are removed from the underlying assets and pretty much money made from money.

Meanwhile, In Islamic finance, structured finance products must be based on “real assets.” Risk must be shared between lender and borrowers and trading excessive risk is prohibited. “Gharar is haram that is bundling the risky loans in the name of securitization without knowing who holds the real estate property,” he stressed.

Charging interest (riba) in the primary market is also prohibited. The transaction should be based on the concept of profit-and-loss sharing or “fixed-cost mark-up.”

In his lecture, Dr Yildirim emphasized that risk management should be done before the crisis, not after. “It is the important, not urgent cases that separate success from average performance. The probability of bubble in prices is small but the consequences are huge “ he stated. He cited the example of Blaise Pascal’s bet (17th century mathematician and physicist) on pressure equals force divided by the area.

“The difference between gambling and investment is in investment, you take calculated risk. Risk management is for hedging not speculation,” he explained.

Dr Yildirim outlined that structured finance offers enormous flexibility to create securities with distinct risk-return profiles in terms of maturity structure, security design and asset type providing enhanced return at a customized degree of diversification commensurate to an individual investor’s appetite for risk.

He added that the premier form of structured finance is capital market based risk transfer, whose two major asset classes, asset securitization (which is mostly used for funding purposes) and credit derivative transactions (as hedging instrument).

“Islamic finance falls within the domain structured finance instrument whenever religious constraints require the replication of conventional interest-bearing assets through structured arrangement of two or more contingent claims,” he stated.

Dr Yildirim  attributed the main cause of the crisis to the failure in ill-designed securitization market. He cited that in particular, uncertainty about the true quality of securitized assets exacerbated the impact of asymmetric information, causing the market failure.

“We have to re-establish the securitization market for a healthy economy. However, credit crisis has eroded the market confidence. This may give a window of opportunity to increase new issues of Islamic asset backed securities for all investors around the world seeking Islamic investment as a means of diversification,” he said.

With the recent financial crisis, Dr Yildirim discussed the various opportunities for Islamic finance and one of which is real estate.

“Housing is one of the basic needs. It is linked to many sectors of the economy. Promoting this sector consequently promotes employment, consumptions and investment in the economy. Housing a blessing from Allah (SWT). It is a place of rest and peace of mind,” he explained.

He cited the huge market demand for housing.IDB member countries need around 8.2M houses per year to accommodate poor and low income urban people. He added that world population will grow additional 2 billion by 2030, meaning roughly there would be 40,000 houses in an hour. 

Dr Yildirim pointed out that expanding housing benefits requires a scalable means of delivering new funds from alternative sources of capital. This capital would most likely come from securitization or sukuk programs. In order to deliver additional funding, capital markets rules as well as core investment entities need to be put into places.

The fundamental difference between Islamic finance and Western interest-based finance is based on how risk is allocated and rewarded in these systems. The core premises of Islam look more to profit and loss sharing. “Every transaction must involved a tangible asset, overcollateralization. It is secured funding such as sale-buyback, lease backed, asset backed (sukuk),” he stressed.

There are three basic forms of Islamic finance such as debt- based contracts (synthetic loans/purchase orders (murabahah) and sale-buyback (bai’al’inah), Asset-based contracts (leases (ijarah) and sale-leasebacks (ijarah thumma al-bay) and equity based contracts (profit-sharing/partnership (musharakah) and sweat capital/seed funding arrangements or trust (mudarabah).

Dr Yildirim also presented some of challenges that Islamic finance has to hurdle such as the lack of financial engineers to develop new product for risk management purposes (most Islamic banks operate as retail bank); shortage of scholars to understand and approve products; lack of unified regulatory framework; and lack of demand among Muslims. “No government is in a position to cope with the current housing funding satisfactorily. The housing sector is too large for any financial institution or government to finance alone. We need a depthless in secondary market to create liquidity in the market. We need more structured finance products. There is a window of opportunities of Islamic securitized (structured) products,” he concluded. The lecture was followed by an open forum as attendees asked Dr Yildirim with Saad Al-Khorafi of KES acting as the moderator.

(Arab Times / 08 Feb 2013)

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