26 July 2016 1

Can a shadow bank redeem the underdevelopment of the Muslim world?

Muhammed Shahid Ebrahim

University of Durham

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I. Motivation

• The purpose of this conceptual note is to discuss a proactive way of harnessing

the power of capital markets to build a better Islamic financial intermediation

system.

• This will stem the long term decline in the growth of emerging Muslim

economies and foster their development.

• This, in turn, will improve the lives of the citizens of these nations.

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II. Current State of Muslim Economies

The total GNP of the fifty-seven Muslim countries is only 8 percent of the world GNP, while

their total population is more than 1.3 billion and constitutes about 21 percent of the world

population. Identically poor results are revealed from an analysis of the Human Development

Index (HDI), as defined in the United Nations Development Program (UNDP). Out of fifty-

seven Muslim countries, twenty-one received low scores, thirty-one countries secured medium

scores and only five Muslim countries attained high scores on the HDI.

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III. Theoretical Assertions

• Financial systems play a vital role in advancing intermediation by mitigating market frictions,

facilitating efficient investment decisions, allocating scarce capital and transmitting financial

transactions.

• This in turn stimulates capital accumulation decisions and technological innovation that are

crucial in delineating a nation’s long term economic path.

• The efficient structure of the financial intermediaries (FIs) is thus of import for the welfare of

its constituent economic agents (see Blejer, 2000).

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III. Contrasting an Islamic Bank with an Investment Company

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III. Step A

• Contrasting the Organizational Structure of an IB with that of an IC. An IB is a less efficient

organizational form as compared to an IC. This stems from two issues:

• One: An IC is a flow-through or a pass-through entity, while an IB is a corporate entity. This

mandates imposition of taxes on the profits of an IB but not that of an IC. This issue has

major ramification on the pricing of the financial facilities of an IB at a higher level (in

contrast to an IC).

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III. Step A (Continued)

• Two: The second contract of Mudārabah on an IB is onerous. This is because when the

savers of funds are asked to share in the risk of the facilities underwritten by an IB, they will

require a higher return (in contrast to an IC).

• Three: ICs are less leveraged than banks and they do not own assets. This makes IBs

relatively more unstable than ICs.

• Result A: The organizational form of an IB is competitively less efficient than that of an IC.

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III. Step B

• One: The financial facilities invested by the IC can be more consistent with the spirit of the

Shari’ah than the ones predominately invested by an IB.

• The bulk (roughly 80% of the assets) of the IB comprise of a buy-sell agreement, involving a

murabaha facility, which does not expunge the agency cost of debt and is tainted by the

element of ribā (see Ebrahim 2016b).

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III. Step B (Continued)

• Murabaha is akin to collateralized debt facility ameliorating asymmetric information

(involving gharar ˗ attributed to adverse selection or/and moral hazard) but endemic in

agency costs of debt.

• This makes it quite controversial as the prohibition of riba an-nasi’ah (deferred ribā) is

attributed to the potential of expropriation of assets of a lender or a borrower ensuing from

the endemic agency cost of debt due to either risk-shifting or underinvestment respectively

(see Ebrahim 2016b).

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III. Step B (Continued)

• This is consistent with the Qura’n (4:161, 30:39), which renounces ribā as it leads

to expropriation of a counter-party’s assets. This attribute of ribā is reflected in the

Sunnah (see Thomas, 2006). It is also reinforced in the classic works of Ibn

Taymiya (1951) and Ibn Qayyim (1973).

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III. Step B (Continued)

• ICs investing indirectly in leasing (ijarah as explained below) (in contrast to

murabaha by IBs) can moderate both asymmetric information (involving gharar)

as well as the agency cost of debt (involving ribā).

• Leasing not only increase the debt capacity of a potential borrower but is also

highly tax efficient (see Myers et al., 1976 and Eisfeldt and Rampini, 2009). This

implies that ICs investing in leasing can offer higher risk adjusted rates of return to

their ultimate stakeholders than IBs.

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III. Step B (Continued)

• The above result not only ensues from the competitive advantage (in the form of

tax benefits) of leasing over asset-backed loans (i.e., murabaha facilities) but also

from the lower transaction costs of ICs over that of IBs ensuing from their

respective organizational form.

• Two: The risk adjusted returns of an IC is expected to be competitively higher

than an IB over the life cycle of the savers of funds. This is explained as follow.

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III. Step B (Continued)

• The life cycle hypothesis, elaborated in Samuelson (1989), sheds light on how economic

agents should employ portfolio theory in different stages of their life.

• Young agents should invest in equities, as their human capital comprises of a stream of

income over their earning life.

• As agents become older, their human capital becomes depleted.

• Therefore older agents need to replenish their depleted human capital with fixed income

securities (sukuk) in their portfolio.

• That is, as agents gets older, halal fixed income securities should replace equities bought

during their younger periods.

• This is the rationale behind life-cycle funds or target-date ICs which do it automatically.

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III. Step B (Continued)

• IBs offer only access to a single investment account, whose payoffs are taxed highly as

current income. This account remains the same over the saver’s lifecycle.

• In contrast, ICs offer access to tax-preferred equity funds for capital growth. In the long run,

the after-tax payoffs of equity are higher (on an ex-ante basis) than that of debt contracts as

illustrated in the well-known Equity Premium Puzzle (see Mehra and Prescott, 1985; Siegel,

1992). This helps savers of funds accumulate capital in the early stages of their life-cycle.

• For savers of funds (investors) in the later stages of their life-cycle, a hybrid facility (akin to a

balanced fund) comprising of a combination (portfolio) of equity and a leasing facility offers

a potentially higher payoffs on an ex-ante basis than a plain vanilla asset backed facility than

an IB.

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III. Step B (Continued)

• Result B: ICs can be deemed to be truly Islamic in spirit even though they do not employ

any of the classic Islamic facilities.

• Result C: ICs have the potential of improving welfare of their constituent savers of funds

on an ex-ante basis as they are more efficient (with less transaction costs) and are more

flexible than IBs.

• Result D: If investors become aware of the potential of ICs in emerging Muslim

economies, they will abandon IBs en masse leading to disintermediation. It is therefore

in the best interest of policy makers in these economies to advice IBs to develop and

integrate their activities with capital market (see Figure 2). This involves underwriting

leasing facilities, securitizing them and developing truly Islamic money market and bond

market ICs. This also involves advancing equity and balanced (hybrid) ICs. These

improvements will foster long term development and stem the ‘long divergence’ of these

economies.

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Figure 2. Advanced phase of financial system architecture

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IV. Conclusion

• Capital market offers avenues of improving the Islamic financial architecture

beyond the current retail Islamic banking emphasizing the controversial murabaha

facilities.

• This is because it offers innovative and truly Islamic approaches to stem the

economic decline of the Muslim world to revitalize growth.

• It will help improve the lives and the future of the Muslim Ummah.

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• To reach the above lofty goals, efforts must be expended to structure efficient

capital market instruments, institutions and markets in tune with the Shari’ah.

This involves joint ijtihad between finance theorist, Shari’ah scholars and

practitioners as advocated in Al-‘Alwānī (1997).

IV. Conclusion (Continued)

Contacts of the presenter Contacts of IRTI

Website: www.irti.org Phone: +966 (0)

126466377

Fax: +966 (0) 126378927 P.O. BOX 9201 - Jeddah

21413 Kingdom of Saudi Arabia

19 26 July 2016