Debt versus equity

Is the rise in Islamic finance providing global regulators with an opportunity to bring about fundamental change in governance, and the demise of the oppressive interest-rate policy, through the adoption of the Islamic principle of shared risk and profit? CARALINE CLARKE explores.

One of the fundamental differences between conventional western and Islamic banking systems is the emphasis placed on debt, as a financing and policy tool, over equity. Western policymakers’ continued obsession with interest and debt is mystifying when the damage it causes was so graphically demonstrated by the 2008 global financial crisis.

The interest mechanism is worthy of scrutiny; the concept of payment for the use of money as if it was a production resource. Through Keynes, Minsky and others, there has been discussion on the validity of the interest mechanism as a way to govern financial markets and concerns over the impact of uncoupling investments from real productive enterprises, creating a ‘veil of money’ distancing investors from real economic activity.

Once money and debt are commoditized, real economic activity can become subsumed under a market structure which permits the construction of instruments such as collateralized debt obligations (CDOs) and credit default swaps, which contribute nothing to the equitable intermediation between deposits and productive investment.

Mechanisms developed through Islamic finance provide credit and monetary policy tools, for example, suitable types of Sukuk structures such as profit-sharing asset certificates.

These instruments link the investor and the physical asset, and cannot be sold or hedged without recourse to the original asset or business. Risk and profit can only be assigned, with no transfer of ownership, unlike the situation leading up to the 2008 crisis where loan originators were able to set up subprime mortgages, commoditize the loan and risk and sell it to investors.

The concept of risk-sharing is alien to modern conventional banking; however, a profit-sharing asset (Sukuk), allows the investor to suffer a capital loss in the event of insolvency. These investments are based on partnership contracts between the customer and the bank which owes a duty of care to the customer. The arrangements take two forms: one where the depositor specifies particular assets that the bank is authorized to purchase or the more common unrestricted type where the deposits can be combined and invested at the discretion of the banks’ fund managers.

These are significant funding vehicles, compliant with Islamic finance principles where the profit is shared between the bank and the depositor.

In reality, the lessons of the global financial crisis have largely been ignored but can be summed up in three Islamic finance principles, with potential policy recommendations.

The first fundamental principle is explained in the following:
• Money should only be used as a means of exchange, it should never be traded as a commodity (including currency speculation), and
• By 2008, financial engineering created a derivatives bubble that was 12 times the value of the global GDP, illustrating clearly that there could be no real asset-backing. Interest, as a payment for using money, has been seen by many as the crucial element to facilitate investment but, as discussed from the foregoing, there are alternatives.

Policy recommendation: Eliminate interest as a payment for using money – debt financing.

The second fundamental principle is explained in the following:
• Financing should be on an equity basis, sharing profit and risk, rather than on a debt basis. Thus, creating a situation where lenders must take responsibility for the outcome of their credit assessments
• Such a reform would present challenges and a need for strong regulation and taxation reforms, much of which are already in place as western financial centers vie to become Islamic investment hubs, and
• It is expected that financial engineers who developed CDOs and credit default swaps would be able to adapt to the new environment and create innovative products properly backed by real assets, and would not allow the excessive leveraging that led to the global financial crisis.

Policy recommendation: Financing economic activity must be through profit-sharing instruments.

Thus, it follows that the third fundamental principle is that:
• The sale of debt is prohibited.

The foregoing applies for a number of reasons. For example, transferring the risk of default cannot be permitted, particularly in cases where the buyer was not aware of the true content of the security, as was the case of CDOs in the US pre-2008, where the reputation of the originators persuaded institutional investors to enter the market. The inaccuracies of the ratings of these securities compounded the errors of the originators.

The Greek sovereign debt crisis clearly illustrates the problem created by an ever-increasing debt mountain with escalating interest charges, where new tranches of bailout funding simply serviced the debt. One solution proposed by Yanis Varoufakis, the former Greek finance minister, was to convert the outstanding Greek program debt into GDP-indexed bonds, or asset-backed securities, allowing Greece to share with its creditors the benefits of recovery, thus the creditor has an interest in the debtor’s economic recovery.

Caraline Clarke is the senior legal advisor with Monetics Singapore. She can be contacted at [email protected]