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Asset-Based & Mortgage-Based Financial Products From an Islamic Perspective

Orientation Workshop and Research Seminar; IsDB / ITI
Nov. 10, 11, 12.
Lessons from the Global Financial Crisis:
The Need for Social Housing Schemes

Seif I. Tag el-Din

No matter how observers may differ about the lessons learned from the current global financial crisis, it all comes down to the significant conclusion that the best assurance for a stable and prosperous global economic order is financial governance of basic needs’ financing (housing, education, health, nourishment etc.) through socially responsible investment schemes, away from speculative and hedging games. Housing, in particular, is a basic human need that can best be provided through socially responsible investment schemes. The sub-prime mortgage financing experience in the US has now stood out as an icon of socially irresponsible housing finance; not the least because huge amounts of taxpayers liquidity has failed to extinguish the global fire sparked through such irresponsible behaviour. To appreciate the scale of damage, just take the American $700 billion bail-out package, which alone equals the total sum of all insurance compensations paid against world disasters (earthquakes, floods etc) that took place over the ten years period 1997-2007. The trillions of dollars spent so far to bail out Western banking system could not only have solved housing problems in the world but contributed substantially towards world poverty elimination. However, this is only part of the opportunity cost of irresponsible financial behaviour. The total cost of damage is still unfolding through poor people of the world getting poorer as a result of the looming global recession, notwithstanding excessive bail out efforts.

It is testing time for the human conscience to learn the lessons, short of reversing the outcome of irresponsible investment behaviour as it is becoming graphically clear. Developed world leaders have acted promptly, resolvedly and uncompromisingly to do ‘whatever it takes’ to avert an imminent worldwide recession. That was the right thing to do in the short term regardless of how well rescue packages have curbed the deepening liquidity crisis. What matters, however, is the long-term economic prospect that has already signalled looming recession into the UK, the US and the rest of the industrial world. In the way to restore confidence in the global financial system, the British Prime Minster, Gordon Brown, called for a comprehensive review of the world economic along the spirit of post-war Bretton Woods agreement. This has already taken effect through the American president’s initiative to hold a world economic summit next November in Washington, to discuss strategic issues about the future trend of the world economic order in the light of the present global financial crisis.

Towards More Socially Responsible Islamic finance
Times for reflection on bitter global financial market experiences are also times for recovery from inertia and path-dependence, which, admittedly, remained the daunting syndrome of Islamic financial innovation since the early 1990’s. Calling for a more balanced process of financial innovation to meet socio-economic objectives as well formal Shariah-compliant structures, many Islamic economists have vehemently warned against mimicking financial engineering advancements in modern capitalist markets. Regrettably, however, the Islamic industry drifted persistently into a wild impasse of intricate financial engineering, seemingly under the pretext of proving the ability of Shariah to satisfy all investors’ needs. In the first place, what matters is not the ability of Shariah to meet investors’ needs; it is rather the ability of Shariah to address people’s basic needs in terms of housing, education, health and nourishment.

Now that insatiable greed of investors and irresponsible behaviour of corporate managers are blatantly blamed for bringing about this historic market failure, it is also good time for Islamic investors and financial practitioners to heed Muslims’ economic outcry for a more socially responsible Islamic financial industry. The objective of this article is twofold; first, it argues the need for a comprehensive overhaul of existing standards and trends of the Islamic industry to break away from inertia and restore clarity of purpose, particularly as against pressing Muslims’ socio-economic needs. Second, it proposes a radical solution for housing needs in Muslim countries through an ambitious but cost-effective and economically viable housing scheme that spreads the total cost over all banks – Islamic or conventional – through a package of sociable responsible syndication based on the Istisnaa’ mode. The idea is to create a strong will among banks to address basic human needs and to take part in bailing out extreme poverty.

The needed comprehensive overhaul
In a recent lecture at MIHE, M. A. Zarqa pointed out to the importance of separation of powers in the interaction between Shariah advisory service (at the initial stage of product development) and Shariah auditory service (at the final stage of validation), which arguably is lacking. He succinctly compared the current performance of the Islamic financial industry under Shariah auditory leadership to a situation where ‘judge’ and ‘solicitor’ in a court of law is one and the same person. Whether or not the missing separation of powers has adversely affected the quality of Islamic financing products, this remains to be ascertained through future inquiry. Yet the absence of a regulatory mechanism to ensure such separation is truly alarming. What matters is not the obvious case where a Shariah scholar may act at both the development stage and the auditory stage in a specific company or activity. This is relatively rare and easy to avoid! Rather, it is the fact that all Shariah scholars are already engaged in product development stages across different companies and activities, thereby, yielding a continuous stream of financial products responding to a variety of investment needs. Yet to command the needed Shariah legitimacy, this has to be validated by an independent panel of judges who must have taken no part in the development process. This is regrettably lacking.

The present self-regulatory scheme in the Islamic financial industry is reminiscent of the middle 1980s self-regulatory regime that dominated the British economy after the 1986 financial revolution in London Stock Exchange, metaphorically called the Big Bang. Arguments against statutory regulation within British financial system were rife during the 1980s. Proponents of the self-regulatory regime believed that statutory regulatory approach was only a recipe for killing creativity and stifling financial market innovation. Professional experts of the industry, it was believed, were more qualified to tackle regulatory issues of their own industry than non-experienced government officials. To keep the Government at arms’ length, the official regulatory burden was delegated to professional experts who presided over various self-regulatory circles including specific members of the financial intermediary industry. Members were free to align themselves with any appropriate self-regulatory circle that matched their industrial activities. Banks, insurance companies, pension funds and various investment and financial intermediaries were typical members of self-regulatory circles.

Yet the shattering blow came from the self-financing property of the self-regulatory system, which depended on membership subscriptions. This had effectively accounted for a competitive atmosphere among leaders of self-regulatory circles for more members, thereby leading to lower subscription fees and eventually to compromising the quality of supervision. ‘Competitive laxity’ is the term that came to be used to describe the above problem but it was not the only source of concern. Industrialists cared more for past and future affiliations within their parent industry than for the interest of outsider ‘consumers’ – i.e. the general public who buy insurance policies, investment certificates, pension fund plans etc. Therefore, failure of the self-regulatory system came as no great surprise. The immediate victims of the above competitive laxity were consumers and hence there was a strong case to protect consumer interests through recovery of the statutory regulation system in terms of Financial Services Authority.

The self-regulatory scenario in the Islamic financial industry is not much different from the above, particularly in terms of the self-financing property and the spirit of closed industrial affiliations as against the interest of outsider consumers. Perhaps, the only exception is that the interest of Islamic ‘consumers’ is not measured in monetary terms. The direct interest of the Islamic consumer is to get reliable assurance of Shariah compliance as regards investment and financial products but there is no material liability against such an assurance in this worldly life, except for the fear from God in the Hereafter. There is yet another indirect interest of Islamic consumers even though they may not be involved in business transactions, which relates to ‘socially responsible’ investments that benefit a wider community. It is an important Islamic duty but self-regulatory systems are typically closed within industrial boundaries. There is yet an additional factor in the Islamic self-regulatory system that makes the situation even worse. It is particularly the status of financial and investment institutions as ultimate beneficiaries of the whole regulatory activity. Certificates of Shariah Compliance (CSC) are real assets for firms, giving them valuable access to Muslims purchasing power. In fact, the widespread promotion of Islamic financial and investment products is due to vigorous marketing efforts of CSC holders rather than that of CSC issuers.

The dire need for independent statutory regulation of the Islamic financial industry cannot be exaggerated. Admittedly, this is already recognised in the industry in terms the non-profit making organisations AAOIFI and the IFSB but even these bodies are financed by the industry, to set technical regulatory standards for the industry. What is needed is a new Islamic regulatory regime that represents the interest of the industry as well as that of the consumer. Setting an independent judicial panel who work independently of the industry should be the ideal means to protect Muslim consumer interests both directly in terms of Shariah compliance assurance and indirectly in terms of directing the industry towards socially responsible investment. Fundamentally, the body should not get financing in whatever form from the industry and therefore should be under no pressure either directly or indirectly from the industry. The point should not be misunderstood to imply any lack of appreciation to the positive role played by the Islamic financial industry in developing Shariah-compliant alternatives to Muslim investors and consumers. This is absolutely out of question. However, it is just timely to care for issues about quality standards and greater emphasis on originality and clarity of purpose as the Islamic financing experience already entered its the forth decade. It is beyond the scope of this article to elaborate on the legal and institutional character that the proposed judicial panel may take. One possible suggestion is to define the needed panel as a sub-set of the present Jeddah-based fiqh academy subject to the basic criterion of not being involved in the process of product development anywhere within the industry..

Social Housing Schemes.
Long term saving schemes are commonly practiced in building societies, and relatively recently in the Canadian Islamic Housing cooperative societies, which set out to engage individuals since early stages of their lives in saving plans that lead them gradually towards the objective of owning a house. Saving scheme s, it must be emphasised, operate along the same balance-sheet principle of asset-transformation that characterises financial intermediaries in general; that is, transforming a large pool of small liabilities into substantive assets. Yet the distinctive feature of specialised housing finance vehicles is to devote such asset transformation service for an earmarked objective and to the exclusive benefit of members. The Malaysian Tabung Hajji stands out as one of the earliest, yet, most thriving experiments of socially responsible long term Islamic finance. It is a living example to show how small saving schemes can meet expensive ends – in this case performing the fifth pillar of Islam, Hajj with possible return.

As it seems, the virtual absence of socially responsible investments in the agenda of commercial banks – both Islamic and non-Islamic – is more of a capitalist business temperament than a pure matter of economic viability. Yet the Western leaders’ pledge ‘to do ‘whatever it takes’ to rescue the global financial order out of tax-payers money should justify a parallel pledge to involve capitalist institutions in a socially responsible package to resolve a chronic housing crisis of low income communities.. No high brow ‘financial engineering’ or technical trick is needed in bailing out the social crisis as there was no such trick in the way Western leaders acted concertedly to bail out the global capitalist system. It is simply social responsibility, coupled by strong will, to commit strategic funds that pay off economically from social investment schemes. Obviously, this cannot be done through ‘killing the goose that lays eggs of gold’. It is beyond question that maintenance of a resilient banking system is a key factor in economic prosperity and that the bailing out of banks from taxpayers’ money in the ensuing global crisis has been a legitimate social responsibility. However, the rules of the game must take a new turn after the hard lesson about the nature of social contract that helped to shore up capitalist institutions.

The above sense of duty is all the stronger towards Muslim communities, now that we are concerned with the Islamic financial industry. It is not merely a matter of social contract between taxpayer and the banking system. It is rather the additional duty to pay back some of the benefits of Islamic legitimacy to the Muslim Ummah which, after all, is the ultimate issuer of legitimacy and hence the real stake holder of the whole experience. Apart from the definite social rewards, the creation of a new environment of Islamic banking involvement into socially responsible housing schemes is a recipe to spark a nation-wide economic boom that creates jobs and accelerates growth at macroeconomic machinery. Hundreds of thousands, if not millions, of newly married and young start-up families keep struggling hard with housing problems even though national residential plans are not often a major problem in most Muslim countries. Few can afford commercial banking mortgages – even if Islamic – as the financing problem that matters most. Hence, the challenge is to create an economically viable, though socially rewarding housing schemes, to satisfy such an important social need. To spread the financial risk and allow for wider sharing of returns, the required finance can be raised through the structuring of banking syndications involving Islamic as well as Islamic banks. Special purpose vehicles can then be established to perform an important agency role between banking syndications and the end beneficiaries of the housing schemes. This will then make up for inviting building contracts for housing schemes and negotiating their financing through Istisnaa with relevant banking syndications. This is a familiar framework in Islamic banking which needs no more elaboration. As mentioned earlier, the challenge in social investment schemes is not highbrow financial engineering, but strong will.

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