1 Financial Engineering and Evaluation of New Instruments Dr. Munawar Iqbal Chief of Research (Islamic Banking and Finance) IRTI, Islamic Development Bank.

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Financial Engineering and Evaluation of New Instruments

Dr. Munawar IqbalChief of Research (Islamic Banking and Finance)

IRTI, Islamic Development Bank

DLC Lecture

November, 2004

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Definition of Financial Engineering

Financial engineering can be defined as ‘the design, development, and the implementation of innovative financial instruments and processes, and the formulation of creative solutions to problems in finance’.

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Need for Financial Engineering in Islamic Finance

Until now, the Islamic financial tools have essentially been limited to classical modes developed centuries ago. They were developed to meet the needs of those societies. While they may serve as useful guidelines for contemporary Islamic contracts, there is no reason to be restricted only to those. Financial markets are becoming more and more sophisticated, and competitive. In order to exploit the fast changing market environment and face increasing competition, financial engineering and innovation is imperative.

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Scope for Financial Engineering in Islamic Finance

Financial needs of both individuals and businesses have changed. Engineers in modern finance have designed several new ways such as mortgages, options, derivatives, hedging, insurance pension plans, credit cards etc., to meet those needs. We must examine what needs are being fulfilled by these instruments. If the needs are genuine (Islamically speaking), then we must either adapt them for our purposes or invent Islamic alternatives for them.

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Scope for Financial Engineering in Islamic Finance-Cont.

In the light of the principles of maslaha and istihsan, a “needs approach” to financial engineering is desirable, of course within the known principles of Islamic finance. In this regard, the example of bay‘ salam is very important to remember. In general, it is not allowed to sell anything, which is not in one’s possession. But in case of salam, the Prophet (pbuh) allowed such sale because of “need” of the people, but laid down clear rules to protect the interests of both parties.

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Scope for Financial Engineering in Islamic Finance-Cont.

The process of adaptation is well recognized in Islamic fiqh and has never stopped. However, its speed needs to be greatly enhanced. Classical contracts have been modified in a number of cases to meet current needs. One potent example is the initiation of Islamic banking on the basis of al-mudarib udarib principle, which provides that a mudarib (agent) may himself appoint another agent to actually run the business. Another is the practice of murabahah, through which the bank buys merchandize upon the promise of another party to purchase it from the bank at a higher price.

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Scope for Financial Engineering in Islamic Finance-Cont.

The principle of al-mudarib udarib essentially allows for sub-contracting. If the principle is acceptable, there is no reason to restrict it only to mudarabah. Contracts can also be designed on the basis of other principles, like al-muajjar uajjir, al mustasna’ yastasna’, etc. In other words, the original contractee may arrange to fulfil the obligations under the contract through third parties. That the principle is acceptable from an Islamic point of view is not questionable.

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Scope for Financial Engineering in Islamic Finance-Cont.

While it is possible to modify classical contracts to suit modern conditions, a much broader scope for financial engineering exists in developing new contracts. These contracts could be hybrids of old contracts or may be entirely new. The scope for financial engineering, and for that matter for innovations in other fields, is quite wide. It is important that the task is given over to those experts who know the needs and niceties of the trade.

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Two kinds of Ahkam

Ibadat and Muamalat

The general principal in case of ibadat is that nothing is that an act is ibadah only when permitted by God.

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The Doctrine of Original Permissibility

In case of muamalat, the general principal is that of ibaha, i.e. everything is permitted unless clearly prohibited by God. We call this the Doctrine of Original Permissibility.

For prohibitions, Shariah provides general guidelines to be observed. The interpretation of these guidelines in every age is done through the process of ijtehad.

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Guidance From Quran on Business Dealings:

• بالباطل بينكم أموالكم التأكلوا آمنوا الذين أيها يامنكم تراض عن تجارة تكون أن .إالاآلية )– النساء، (.29سورة

• “O Ye who believe! Eat not up your property among yourselves unduly. Let it be trade amongst you by mutual agreement”.

• This verse is perhaps the most important verse of Quran on economic matters. It tells us both the do’s and the don’ts in business dealings.

• First the don’ts.

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What is Prohibited in Business Relations

The verse rules out ALL illegal ways of wealth creation. “Batil” encompasses any way of acquiring wealth that violates the rights of:

(a) God (b) Contracting Parties and (c) Third Parties

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Prohibitions-I

First and foremost those ways of wealth creation are ruled out that are declared “illegal” by the Supreme Law Giver. Examples of these are riba, gharar, qimar.

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Prohibitions-II

The scope of the verse also includes all those activities, which are declared “illegal” by the state and its various echelons. Examples of these are bribery, smuggling, money laundering.

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Prohibitions-III

• Ways of creating wealth that violate the rights of third parties are also prohibited. Examples of these are creating pollution, obstructing common passage ways and other negative externalities. Zoning regulations by municipalities are covered here

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Kinds of Contracts

• Islamic contracts can be broadly classified into two categories:

• Charity (Tabarruat) and

• Exchange (Muawadat).

• In this lecture our interest is in the latter.

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Guidelines for Financial Contract Design

• Freedom in determining the conditions of a contract within Shariah rules.

• Prohibition of taking others’ property without compensation

• Conscious Agreement within Shariah limits• Mutual Benefit (Value Equivalence)• Justice and Fairness (Elimination of Exploitative

Clauses)• Provision of Maximum Possible Information• Honouring the Spirit of Contract

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What is Allowed in Business Contracts

The Golden Principle of Free Choice

• حالال المسلمون حرم أو حراما حلل شرطا إال شروطهم عند

•“Muslims are free to determine the conditions of their contracts unless they make something forbidden as permissible or something permissible as forbidden”

In Islamic theory of contracts, parties are free to agree on any terms as long as known Islamic rules and principles are not violated.

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Financial Contracts: Special Conditions to be Observed

Prohibition of RibaProhibition of GhararProhibition of Gambling

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Prohibition of Riba

• Riba literally means increase, addition, expansion or growth.

• In the Shari’ah , however, the term riba refers to anything (big or small), pecuniary or non-pecuniary, in excess of the principal in a loan that must be paid by the borrower to the lender along with the principal as a condition of the loan or for an extension in its maturity.

• In this sense, Riba has the same meaning and import as the contemporary concept of interest in accordance with the consensus of all the fuqaha (jurists).

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Prohibition of Gharar

• Gharar refers to act and conditions in contracts, the full implications of which are not clearly known to the parties.

•  In economic parlance it is very close to “Asymmetric Information.”

• It has two kinds: gharar yaseer (trivial) and gharar fahish (substantial).

• The first kind is tolerated since this may be unavoidable without causing considerable damage to one of the parties.

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Prohibition of Gambling (Maysar)

يا أيها الذين آمنوا إنما الخمر والميسر واألنصابواألزالم رجس من عمل الشيطان فاجتنبوه لعلكم

تفلحون ).90سورة المائدة، اآلية(

O Ye who believe, Intoxicants and Gambling, (Dedication of ) stones, And (Dedication of) arrows, are an abomination, of Satan’s handiwork: Eschew such (abomination) , That ye may prosper.

Gambling amounts to transfer of wealth without any value added.

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Some Relevant General Principles of Shari’ah

• No pain no gain (Al- Kharaju Bil-Daman)

• Principle of Relief (Istahsan)

• Doctrine of Necessity (Dharoorah)

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The Four Cs of Islamic Financial Engineering

• In addition to the Doctrine of Original Permissibility and the Golden Principle of Free Choice and the discussion of the few prohibitions, we can summarize the guidelines for financial engineering in what we call “Four Cs of Islamic Financial Engineering”. These are:

• Consciousness• Clarity • Capability

• Commitment

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Consciousness

That the parties should consciously and willingly agree on the conditions of contract without compulsion or duress. An implication of this is that any agreement made in the state of unconsciousness (like under the influence of intoxicants or imposed by force ) is not valid.

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Clarity

That the parties are fully aware of all the implications of the conditions laid down in a contract. Any ambiguity (with the exception of gharar yasir) will make the agreement invalid. An implication is to minimize asymmetric informatiom.

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Capability

That the parties are reasonably certain that they are capable of complying with all conditions of the contract. An implication of this is that sale of any goods (or services) which are not owned and possessed by the seller at the time of the contract is not valid.

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Commitment

That the parties intend and are committed to respect the terms of a contract both in letter and spirit. An implication of this is that any subterfuge to go around any Shariah condition through linguistic or legal tricks is not allowed.

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Comments on Some Recent Contracts

• Sukuk

• Tawarruq