Conceptual Approach to Identification of Fault Lines in Conventional Financial System’s Risk Transfer

A Case for Risk Sharing in Islamic Finance

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The concepts, theory, and practice of risk sharing as enshrined in Islamic finance remain a real mechanism for widening the space for participation in economic activities for growth and development. The perceived propensity for greater risk sharing derivable benefits, which mutual efforts enjoyed in Islamic finance engender, is at variance with risk transfer in a conventional financial system. Indeed, risk sharing takes center stage in Islamic finance as a catalyst for business inclusion, thus accommodating the poor more in economic activities. Many fault lines have been identified in existing practices in conventional systems, through risk transfer, which voids the essence of its institution as a nebulous structure to fund economic activities. The dysfunctional outing of conventional finance risk transfer mechanism is rarely documented. Hence, the efficacy of Islamic finance risk sharing mechanism that ought to be harnessed has not been adequately brought to limelight. Consequently, the primary objective of this paper is to present a conceptual discussion on risk, arguments about Islamic risk sharing practice, and fault lines that inherently characterise conventional risk transfer mechanism. The paper argues for a reintroduction and strengthening of other crucial players’ relevant activities for such to be harmonised in the interest of the overall financial system stability.

What is a risk?

Risk is broadly seen as something that is about the probability of negative outcome or potential losses that could bring an adverse impact to a firm happening. Such negative outcome could be as a result of an unexpected event arising, either from factors within the organisation/business such as staff negligence, mismanagement, or external forces outside the organisation/business (such as sudden or drastic regulatory changes, un favourable economic situations, as well as other changes in tax or interest rate structure that have significant impact on the business’s performance.). Risk can also be viewed in terms of uncertainties of future events happening which might influence successful achievement of an organizations objectives and targets.  Risk is again defined as exposure to uncertainty of outcome or the possibility that the actual returns will deviate from the expected returns. In many conventional finance studies, risk relates to uncertainties that could result in financial loss. Risks may come from uncertainties in unexpected fluctuations in assets prices, in interest rates, project failures, legal liabilities, accidents, natural causes and disasters as well as deliberate attacks from an adversary.

In Islamic perspective, risk is an Arabic word that means Mukhatharah. Previous scholars have provided a more definite distinction between Mukhathatarah and Gharar. Mukhatarah implies risk while Gharar refers uncertainty. Thus prohibition of Gharar is seen as a way of mitigating risk by avoiding deals with high informational asymmetry. But risk in Islamic parlance goes far beyond financial loss because it may start from the failure of fulfilling the promise or the aqad between two parties in a contract. When the two sides or individuals agreed, each team has agreed or promised to deliver their respective responsibilities arising holistically, as laid down in the approved contract. Thus, failure by one side to honor its obligation is tantamount to the risk of breaching the contract. In Islam, violating an agreement has far-reaching repercussions regarding fear of the wrath of Allah. Also, the breach of the contract would bring in injustice to the other party and possibly more negative implications to the Ummah.

Risk sharing being a mechanism for shared prosperity among humans has attracted a plethora of discourses in Islamic finance scholars’ community, which view it as the defining principle of Islamic finance, with its many benefits and potentials.

This general view on the true nature of risk sharing in Islamic finance is however not shared by few scholars. One of the arguments made was that mudharabah, being a point of reference in depicting risk sharing nature of Islamic finance, was an economic institution born of temporal compulsions not only in Arabia but across the world. The central theme in this argument was that Islam encourages profit sharing of which sharing of risk becomes an arising consequence and not the cause in itself. This view is however alien and incorrect given the fact that what is relevant here is the endorsement of the institution of mudharabah in Islam, in the face of its risk sharing attribute emanating from information asymmetry problem, even though it originated from pre-Islamic era. This is more glaring given that where financial losses arise; the entrepreneur unless found negligent, loses not the money but his efforts and time that becomes waste.

The Fault Lines in Risk Transfer for Conventional Finance

The barrage of definitions on risk transfer, tend to converge on one central issue of moving potential losses likely to be suffered by the financier in its totality, away to the other party of the deal. Many operational problems and designs in the financial system that anchored on risk transfer doctrine tend to provide a recipe for chaos. Since risk is assumed to have been transferred to the recipient of funds, who in the eyes of the fund’s owner has no observed alternative, there exists predilection for free credit extension by conventional banks and the financial system as a whole. The economic system, more often than not, pays only lips service to strict credit proposal evaluation because of the false belief that no losses expected, for the deficit unit is hamstrung.

Allied to the above is the existence of inflationary pressures created by un-restrained credit expansion that are sometimes bereft of responsibility and prudence, which later becomes the subject matter for monetary policies formulation and implementation. The resultant effect on the system is seen in policy somersaults that frustrates financial inclusion right from micro finance level and extends to other wider levels. As such, the vulnerable poor are not better anyway as they are further pauperised by more financial exclusion and not financial inclusion.

Furthermore, the likelihood for accumulation of debt occasioned by penchant for giving risk transfer laden loan packages, which normally end up in fresh capital injections to sustain comatose entities, and usage of debt equity swaps, exacerbate low financial inclusion that leaves the vulnerable low income class to bear the brunt of economic malfunction. Thus, potentials for entrepreneurship anchored on shared prosperity inherent in Islamic risk sharing finance are not promoted, a move that could have brought higher economic growth.

Another point of reference as a fault line in the risk transfer based financial system is the proliferation of fictitious assets that have the tag of derivatives, with their accompanying trading volume worth $600 trillion. In fact, 92% of the world’s 500 largest companies use them to lower risk.

The views expressed in this article are the author’s own and do not necessarily reflect Saray Consultancy’s editorial stance.

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