The concept of tawarruq (specifically organized tawarruq) is a controversial one among many commentators and Shari’ah scholars, although it is widely used in Islamic finance, particularly as a substitute for an inter-bank money market product. A paper presented at an OIC Fiqh Academy (see link to the left) puts the role of finance within Islam into a context. I think it is use -ful for explaining where the line is drawn between acceptable and not acceptable when the products look similar:
“Financing is essentially intended to facilitate exchanges and to serve real productive activity; the return on financing becomes deserved when it is a cause of wealth creation. [The relationship is inverted when] exchange becomes a means and financing becomes the goal, and the sale becomes ancillary instead of primary.”
The OIC Fiqh Academy Shari’ah Board has ruled that organized tawarruq is not Shari’ah-compliant, a ruling that has been largely ignored in practice as the use of tawarruq continues. The main difference between organized and classical tawarruq (the board allowed the latter) is that in an organized tawarruq the sequence of transactions is organized by the buyers and sellers of the commodities, even if each transaction is legally independent of the others.
In the past I have supported the use of organized tawarruq out of the need for products that can be used inexpensively for inter-bank liquidity management (and I have deferred any judgment of the Shari’ah-compliance to the scholars who have approved it). However, the description above clarifies for me the distinction between many Islamic finance products and their conventional analogues.
It is always a difficult task to explain how products which have the economic outcome as conventional interest-based loans are different, but I think the description above for distinguishing between different forms of financing based on sales is useful. There remains a lot of formalism in the distinction (in a mortgage the bank lends money with the house as security, while in an murabaha mortgage the bank buys the property and resells it to the buyer).
But, for describing the difference between a murabaha sale and tawarruq financing, it provides a good way for me to understand the difference.
Earlier this week, I wrote a blog post suggesting that Islamic banks might not be in the best position to use mudaraba and musharaka because it exposes depositors to greater risk than the non-risk sharing products. Instead, I suggested that products like mutual funds—where investors come with an acceptance that they may lose money—is a better venue for the profit-and-loss sharing structure.
After writing the post, I found a paper examining whether there were fundamental flaws in the modern application of risk-sharing products, and suggest that Islamic finance has strayed from the classical forms of mudaraba and musharaka in a way that shifts risk from those who are able to manage it to those who are not. The author, Shinsuke Nagaoka, writes:
“However, the economic wisdom of partnership contracts argued above has some usefulness in that it reminds us of the harmful aspects of the current trend in Islamic finance, which is now replicating securitized conventional finance.”
Nagaoka suggests that products like sukuk al-mudaraba impose risk sharing on the parties, but also add a degree of risk scattering. Nagaoka argues that the risk scattering comes from broadening the number of investors who must engage in costly monitoring of their investment, which will “increase the extent of asymmetry of information in the system”.
Nagaoka compares the risk-scattering effect of mudaraba and musharaka with conventional securitizations that caused the financial crisis, which is not entirely fair since there were many other factors that went into the financial crisis (e.g., re-securitizing securitized products and the use of derivatives to add leverage).
The idea of risk-scattering does have an impact on my argument about Islamic banks using mudaraba and musharaka. Islamic banks are sophisticated enough to manage risk efficiently on behalf of depositors, which limits risk-scattering. However, the use of mudaraba deposits will increase risk-scattering since depositors—most of whom are likely to be small—will have an insufficient ability to monitor the risk of the investments made with their deposits.
When depositors’ expectations about full return of their deposits at any time is combined with their inability to effectively monitor bankers, I think that banking is not an ideal business to incorporate risk-sharing products on a large scale.
The Director of Islamic Banking at Bank Indonesia, Eddy Setiadi, described some of the ways in which government support can help the Indonesian Islamic finance industry “in the form of regulation, issuance of sukuk to finance, as well as placement of funds in the Islamic financial institutions.”
In a blog post a couple of weeks ago, I contrasted the supportive role that governments can play in facilitating Islamic finance by putting it on equal footing with conventional finance with the tax breaks that can benefit in the short term but risk becoming entrenched (like the tax breaks on sukuk), which were absent from the article where I found his quotes.
It is good to hear support coming from Bank Indonesia for ways of stimulating the growth of Islamic finance in the country that do less to distort incentives, particularly in terms of rewarding political connections. However, even avoiding the types of incentives which could become entrenched, there are a few points where care is merited in implementing his suggestions.
Governments should focus on creating an appropriate set of regulations for Islamic banks, but shouldn’t Islamic over conventional banks. Islamic finance is at an early stage in its development in Indonesia so allowing conventional banks with Islamic windows to operate can add competitive pressures for good pricing and service. Allowing only wholly Islamic banks (like Qatar) right now will slow the growth of Islamic finance.
Issuance of government sukuk (and facilitating a liquid secondary market) will provide safe assets for Islamic banks’ balance sheets. Placement of government funds with Islamic banks can also help Islamic banks expand the asset side of their balance sheet, as long as the distribution of these deposits are not subject to political whim (perhaps by making deposits on a pro rata share to the total assets of each Islamic bank as a percentage of the total Islamic bank assets).
Government support for Islamic finance can help, but it should always be designed so as to avoid favoring political connections over competence, and to avoid letting the incentives become entrenched.
A recent report from Dome Advisory, a UK-based Shari’ah and legal advisory firm, included a detailed legal overview of the takaful industry (with some elements of Shari’ah-compliance included). One of the most interesting ideas raised by the two co-authors is that the current takaful models may be overly complex and reverting to a simpler, tried-and-true structure comparable to friendly societies and mutual insurance, with modifications to ensure Shari’ah-compliance, may be a better way to build the takaful industry.
This may be beneficial in growing takaful within the European Economic Area since a UK-based Friendly Society could ‘passport’ across the EEA with fewer hurdles than a firm from outside the EEA. It is less clear from their study whether this would provide benefit for the GCC countries where foreign insurers and takaful operators are restricted by regulations that favor domestic companies (outside of the financial centers like Qatar Financial Center, DIFC, etc).
The primary difficulty they identify is that a de novo friendly society, which must meet minimum capital requirements, is limited in its ability to raise capital to meet them outside of the voluntary contributions from members. The solution proposed in the report is to find established friendly societies that have excess capital that could be used for ‘bolt-on’ takaful units alongside, or supplanting, the conventional business of the friendly societies.
This is an interesting idea because it idea that demonstrates how many of the requirements in Islamic finance are already met in large part by established company structures with no connection to Islamic finance. In the past decades, conventional insurance companies have largely de-mutualized and turned into corporate forms which are more problematic from a Shari’ah-perspective.
These companies have demutualized in part because it is easier to grow and raise capital for expansion if shareholders, rather than policyholders, receive the underwriting surpluses and the profits on the invested premiums.
This has in some cases caused problems where insurance companies have under-estimated their ability to withstand losses on policies they have written (notably with AIG and its massive portfolio of CDS contracts). Perhaps there is some common reason why mutual insurance was more widespread until recently and has more in common with takaful than conventional insurance does now.