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Allah Works in Mysterious Ways Especially in the World of Finance:An argument that social constructivism better explains the challenges of accountability that Islamic finance poses international regulatory institutions better than neoliberalism
LO, Stephen Andrew Kai TaiPOLI 344 A03
Dr. Bartholomew PaudynAugust 12, 2010
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I. Introductioni. Allah Works in Mysterious Ways: Especially in the World of Finance
With its origins in the late 1970s, as an amalgam between traditional Islamic
ethics and modern bourgeois enterprise, Islamic finance, with rapid growth rates (of 10-
15% annually in the 1990s and 2000s), greater profit margins, and innovative financial
engineering, has been one of the fastest growing sectors in the international financial
industry for the past decade (Henry & Wilson, 2005: 2; Khaf, 2005: 22; Modi, 2007: 38).
However, the Islamic financial industry has not successfully achieved a state of financial
harmonization (Modi, 2007: 38), yet it remains poorly understood in both the Middle
East and the West (Henry & Wilson, 2005: 1-3). Unlike conventional financial tools,
Islamic finance is a sector of the financial industry that is theoretically supposed to
conform to strict ethical standards imposed shari’a (Islamic religious) law and rulings,
which prohibit any financial transactions that are considered haram (not meeting shari’a
standards) (Modi, 2007: 38). Islamic finance is also a sector that is still relatively young
in the financial world, and the lack of harmonization and standardization in Islamic
finance poses a major challenge to the proper regulation of the Islamic financial industry
(Hassan & Lewis, 2007: 1-2); this begs the question: Why does social constructivism
explain the existence of regulatory challenges in accountability of Islamic financial
institutions to international institutions better than neoliberalism? With this question in
mind, the reader will observe that this essay argues that social constructivism explains the
absence of a harmonized regulatory regime of Islamic finance better than neoliberalism
especially in the field of corporate accountability, i.e., Islamic financial institutions being
able to honestly account for the operational procedures and investment decisions made on
behalf of their investors.
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ii. Structure of the Argument
Before defending the position that this essay argues for, this subsection will show
the basic structure of this essay. This essay is structured into three sections: I.
Introduction, II. Body, and III. Conclusion: Accommodating Differences in
International Financial Regulation Rather than Coloring the World with One
Monochromatic Brush.
I. Introduction is divided into two subsections: I.i. Allah Works in Mysterious
Ways: Especially in the World of Finance, and I. ii. Structure of the Argument.
Subsection I. i. introduces the significance of Islamic finance to international political
economy by giving the reader a general view of Islamic finance in the world. I. ii. is an
outline of the how this essay presents the argument: Why does social constructivism
explain the existence of regulatory challenges in accountability of Islamic financial
institutions to international institutions better than neoliberalism?
II. Body is divided into three subsections: II. i. The Theories of Neoliberalism
and Social Constructivism, II. ii. Understanding the Governance of Islamic Financial
Institutions and II. iii. The Neoliberal Failure of Regulating Islamic Financial
Institutions. II. i. introduces the reader to the basic premises of the theories of
neoliberalism and social constructivism. II. ii. exposes the reader to the regulatory
structure of Islamic financial governance, and shows that the governance of Islamic
finance is deeply rooted in religious and cultural factors, and that regulating the
accountability of Islamic financial institutions proves challenging especially in fields of
risk mitigation, shari’a compliance, governance power of investors and transparency. II.
iii. provides further evidence to show that Islamic financial institutions have, by and
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large, escaped regulation and monitoring by international regulatory agencies such as the
Islamic Financial Services Board, the International Monetary Fund, the Basel Committee
for Banking Supervision (BCBS), the International Convergence of Capital
Measurement and Capital Standards: a Revised Framework (Basel II), etc..
III. Conclusion will conclude the essay by exposing the failure of neoliberalism
in explaining the regulatory challenge that Islamic finance poses the world of finance,
especially in accountability, and that social constructivism better explains these
phenomena. This section also gives recommendations to further integrate and harmonize
Islamic finance in international political economy in a manner where investors are better
protected, while shari’a law is observed in Islamic finance.
II. Bodyi. The Theories of Neoliberalism and Social Constructivism
Neoliberalism is an analytical theory premised on rationality and contracting to
study the centrality of institutions and organizations in international politics, and their
role in resolving collective action problems (Martin, 2007: 110, 118, 124). Neoliberal
analysts tend to use a principal-agent framework to study how international organizations
and institutions function deliver their mandates (Martin, 2007: 124). This perspective
posits that international institutions monitor, provide assurances that agreements will be
met, and serve as forums where different parties can communicate problems that arise in
coordination and be informed of preferences and constraints that they face (Martin, 2007:
111).
Social constructivism is a theory that has a different ontological approach vis-à-
vis neoliberalism, and is premised on the notion that phenomena, which are socially
constructed, occur across context rather than a single objective reality (Fierke, 2007:
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168). Social constructivism puts an emphasis on the importance of holistic ideational
factors in international phenomena such as norms, rules and language rather than on
rather constant individualist-materialist factors such as monetary reserves and balance
sheets (Cohn, 2010: 114-116; Fierke: 2007: 168; Wendt, 1999: 371). When using social
constructivism to analyze issues in international political economy, epistemic
communities and the influence of the norms and values that they project in governance
are central (Cohn, 2010, 114-116).
ii. Understanding the Governance of Islamic Financial Institutions
Islamic finance exists as an alternative to conventional banking by adhering to
norms that are acceptable under Islamic shari’a law (Hassan & Lewis, 2007: 2). Islamic
finance, when practiced in a hallal (in accordance to shari’a law) manner, strictly
prohibits riba (excess, i.e. interest and usury), maysir (gambling and speculation), and
gharar (unreasonable uncertainty), and requires that Islamic financial institutions benefit
society through the collection of zakat (almsgiving), which is overseen by a special
religious supervisory board, so that operations would help create a fairer and more
equitable society (Hassan & Lewis, 2007: 2-3; Algaoud & Lewis, 2007: 38-47). Islamic
finance, therefore, does not use interest at predetermined rates, but instead operates on a
regime of profit and loss sharing, where investment accounts offer money lending
services and returns that are competitive with those of conventional finance (Algaoud &
Lewis: 47).
Islamic finance has a different set of financial tools from their conventional
western-style counterparts. The bedrock of Islamic financial mediation is the mudarabah
(investment) contract (van Greuning & Iqbal, 2007: 16-17). Investors would deposit their
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money into their investment account for the Islamic financial institution to manage by
lending money to other enterprises that will use the money in asset-backed financial
claims or profit sharing and loss bearing schemes (van Greuning & Iqbal, 2007: 22).
However, there is a tendency for investors, and as a result, Islamic financial institutions,
to be conservative in the profit sharing and loss bearing schemes, which have few
institutional infrastructures to such schemes (van Greuning & Iqbal, 2007: 22). This
contractual institution in Islamic financial institutions creates a situation where
depositors/investors are acting as if they were shareholders of securities (van Greuning &
Iqbal, 2007: 22-23).
With this alternative financial model, Islamic finance has, at present, its plethora
of regulatory structures such as the Islamic Development Bank Group, Accounting and
Auditing Organization for Islamic Financial Institutions, Islamic Financial Services
Board, etc. Under the leadership of the Islamic Development Bank, and with the support
of the World Bank, IMF and the Basel Committee, there has been a push towards a
strengthening of the regulatory structure of Islamic financial institutions through greater
regulatory harmonization (Iqbal, 2007: 382). However, these regulatory reforms face the
unsavory possibilities of having regulatory agencies duplicate regulatory competences
and being whitewashed in order to be regulated with conventional financial institutions
(Iqbal, 2007: 382).
iii. The Neoliberal Failure of Regulating Islamic Financial Institutions
Another challenge that regulators of Islamic finance also face problems of
corporate accountability. Islamic finance is based on the adherence to shari’a law, and
has cultural particularities that do not exist in conventional banking (Bahmbra, 2007:
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203-204). Risks that are identified in Islamic finance, such as defaulting debtors might
not be as easily resolved as in conventional banking due to shari’a law, since penalty
clauses are haram (Bahmbra, 2007: 203). Non-compliance with shari’a, also tarnishes
the confidence of investors of the Islamic financial institution or even towards the
industry itself, and requires a Shari’a Supervisory Board to ensure compliance with
shari’a practices by issuing rulings and fatwa, which need to be circulated and
implemented by the firm (Bahmbra, 2007: 205). Holders of investment accounts with
Islamic financial firms have far less governing powers than investment accounts of
conventional financial firms, since the investor has no governance over how the money is
invested, unless he or she terminates the mudarabah contract that he or she has with the
Islamic financial institution (Archer & Karim, 2007b: 320). There is also a lack of
transparency in how accounts are managed, and as a result, investors might not have
enough information to make informed investment plans when putting money into their
Islamic financial contracts and to be ensured that the Islamic financial institution is sound
and operating in an honest and disciplined manner within the confines of the market
(Archer & Karim, 2007b: 328-329).
On another note, Islamic financial institutions are normally regulated by national
central banks, and are usually treated not too differently from conventional commercial
banks, even though their business models are rather different (Archer & Karim, 2007b:
333). This approach is problematic because most central banks tend to protect depositors
more than investors, while most Islamic financial institutions tend to have a convoluted
conception of investor and depositor, where profit is involved (Archer & Karim, 2007b:
333). It is very likely that Islamic financial institutions would require a different
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regulatory approach from what is presently practiced that both treats Islamic financial
institutions both as banks and securities (Archer & Karim, 2007b: 333-334).
Another challenge that Islamic financial institutions provide the international
regulatory regime is that Islamic financial institutions do not fall neatly under Basel II,
which was introduced by the BCBS to better mitigate risks, ensure financial stability,
increase market confidence and provide investors with reliable information about the
health of financial institutions. Basel II is divided into three “Pillars”. Pillar 1 provides
new solutions to credit risk from the operational risks outlined in the 1988 Capital Accord
(Basel I). Pillar 2 addresses the supervisory review process from the perspective of the
responsibility of the supervisor to promote the stability of the banking system, set up
common guidelines for supervisory review and the importance of dialogue between
supervisors and banks. Pillar 3 outlines the minimum number of public reporting
standards on risk and risk management so that market participants can be aware of a
bank’s risk profile and the adequacy of its capital relation to the bank’s risk profile,
thereby involving the market in the capital adequacy regime (Archer & Karim, 2007a: 2).
There remain major challenges in ensuring that Islamic financial institutions do
not take excessive risks that could potentially destabilize the Islamic financial industry
under Pillar 2 such as terrorism, legal risks especially in instances that are precedent
setting or require litigation (Nakajima & Rider, 2007: 342-343, 350, 357). Under Pillar 3,
regulators face challenges in ensuring transparency via information disclosure that must
be credible so that investors could make informed investment choices and ensure that
Islamic financial companies adhere to the regulations to which they are subject to so that
investors and regulators can name and shame, and impose sanctions on the governing
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bodies of Islamic financial institutions that do not follow the regulations (Abdullah, 2007:
377-378). Norms and best practices will need to be introduced to ensure that Islamic
financial institutions function in an responsible manner without taking excessive financial
risks especially when such norms and best practices are not yet in place.
III. Conclusion
After reviewing the dynamics in the regulation of the Islamic financial
institutions, it is very clear that Islamic finance, as an industry, though full of regulatory
challenges in regards to accountability, is firmly rooted in the traditions and ethical
framework of shari’a law and ruling, which are the norms that devout Muslims adhere to
in their daily dealings in the world. These ideational factors are of utmost importance in
the institutionalization of norms and practices in the relatively new industry of Islamic
finance, especially when the regulatory structure in place is not strong enough to properly
regulate the industry. Islamic finance, although quickly growing does not rely on the
financial tools available to conventional finance, especially those that bare interest,
thanks to the norms that religious scholars and Islamic financial traders have decided to
adhere to in the industry. This shows that in Islamic finance, norms and values are far
more important than profits that are made from a purely rational-choice perspective,
especially when Islamic financial institutions have an aversion to practices that are
normally considered acceptable and perfectly legal in conventional finance.
From these observations, it is apparent that neoliberalism, which is premised on
rational choice and the role of institutions acting as a forum where problems of
coordination, regulation, insufficient confidence, communications of preferences and
restraints are resolved, fails to explain the peculiarities of the accountability of the
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Islamic financial industry which challenges the transnational neoliberal regulatory
regime, especially when Islamic financial institutions are not just-for-profit institutions
that have a duty to give back to society. Social constructivism, on the other hand, takes
into account the cultural and ethical tendencies that helped construct the Islamic financial
industry, as well as the still-under-construction regulatory regimes that still have
immense regulatory gaps that still need to be closed but not duplicated and best practices
that still have yet to be determined.
On afterthought, although the fast-growing industry of Islamic finance requires
more effective regulation, greater harmonization and standardization and a different
regulatory approach vis-à-vis conventional banking, these norms and regulations cannot
be implemented without expert advice formed in the epistemic communities of mullahs,
financiers and central bankers. If Islamic finance is to be a force in international political
economy that will be of great significance, international organizations and other
supervisory bodies need to modify their regulatory practices so that the Islamic financial
industry would be properly monitored and become more transparent, thus providing
investors with sound information, and be able to manage risks more effectively. These
proposed changes in financial regulation can pave the way to a global financial system
that operates more efficiently while allowing for greater diversity and choice for investors
who are conscious of ethics and norms. This essay strongly defends that social
constructivism, an ideational theory, better explains the changes that the Islamic financial
industry is going through in terms of corporate accountability and regulation than
neoliberalism, a substantive theory based on rational-choice, i.e., profit-maximization.
After observing these points, other questions that the argument of this essay can lead to
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are: Do neoliberal institutions stifle innovations that exist in the free market because of
bureaucratic dogma and inefficiency? Does financial reform and harmonization require
an ideational shift?
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