Financial Innovation and Engineering in Islamic Finance (eBook)

Preface 7
Acknowledgement 10
Contents 11
List of Figures 17
List of Tables 18
List of Common Abbreviations 19
Chapter 1: Introduction 20
1.1 Background 20
1.2 Importance of Financial Innovation: Realising the Potential 21
1.3 What Makes a Bank Islamic 23
1.4 Values Embedded in the Islamic Banking Products 23
1.5 If All Banks Adopted Islamic Values, Would There Have Been a Banking Collapse? 25
1.6 Significance of this Book 25
1.7 Motivation of the Book 26
1.8 Objectives of this Book 27
1.9 Contribution of the Book 27
1.10 Potential Implications of this Book 28
1.11 Outline of the Book Chapters 28
Chapter 2: The Context of Islamic Banking and Finance 33
2.1 Introduction 33
2.2 Defining Islamic Finance 33
2.3 The Prohibition of Riba in Islamic Finance 35
2.4 The Ethical Basis of Islamic Finance 35
2.5 The Concept of Growth and Purification in Finance 36
2.6 Islamic Finance Instruments 36
2.7 Shariah Compliance and Governance (SCG) of Islamic Financial Institutions (IFI) 38
2.8 Duties and Responsibilities of the SSC 40
2.8.1 Concept and Structure of Financial Products 40
2.8.2 Documentation 40
2.8.3 Shariah Advisory 40
2.8.4 Providing Shariah Legal Opinion 41
2.8.5 Undertaking Shariah Compliance Audit 41
2.9 Major Differences Between IFIs and Their Conventional Counterpart 41
2.10 Financial Innovation and Engineering 41
2.10.1 Scope of Financial Innovation and Engineering 43
2.10.2 Innovation and New Product Development in Finance 43
2.11 Conclusion 44
Chapter 3: Analysis of Financial Innovation and Engineering in the Literature 45
3.1 Introduction 45
3.2 Differences Between Islamic and Conventional Banking 46
3.3 The Difference Between Usury (Riba) and Interest 46
3.4 Emergence of Islamic Banking 47
3.5 Islamic Banking and Finance: Critics and Defenders 49
3.6 Innovation 50
3.6.1 Definition of Innovation 50
3.6.2 Nature and Theory of Financial Innovation 51
3.6.3 Three Schumpeterian Schools of Innovation 52
3.6.4 Innovation Orientation 53
3.6.5 The Relation Between Innovation and Financial Crisis 54
3.7 Product Development 55
3.7.1 Definition of Product Development 55
3.7.2 Importance of Product Development 55
3.7.3 Product Development Process 55
3.7.4 Product Development in Islamic Banking 56
3.7.5 Islamic Ethics and Financial Product Development and Engineering 57
3.8 Regulatory Challenges 58
3.9 Risks in Islamic Banking 59
3.9.1 Credit and Market Risks 60
3.9.2 Operational Risk Exposure of Islamic Banks 60
3.9.3 Impacts of Basel III on Islamic Banks 61
3.9.3.1 Current Scenario 61
3.9.3.2 Capital Impact 61
3.9.3.3 Leverage Ratio 62
3.9.4 Liquidity in Islamic Banks 62
3.10 Corporate Governance 63
3.11 Islamic Economics and Ethics 64
3.12 Legal Stratagems (Hiyal) in Islamic Commercial Law 65
3.13 The Role of Islamic Finance in Tackling Financial Exclusion 66
3.14 Conclusion 67
Chapter 4: A Historical Analysis of Financial Innovation in Islamic Economics and Finance from Inception to the Sixteenth Cent... 69
4.1 Introduction 69
4.2 Phases of the History of Islamic Finance and Its Innovation 70
4.2.1 Phase 1: Formation (622-661) 70
4.2.1.1 Currency Exchange 73
4.2.1.2 Credit Sale and Mortgage 73
4.2.1.3 Murabaha Sale 74
4.2.1.4 Forward Sale (as-salam Contract, Sales in Which a Price Is Paid for Goods to be Delivered Later) 74
4.2.1.5 Transference of a Debt from One Person to Another (Al-Hawaala) 74
4.2.1.6 Representation, Authorisation and Business by a Proxy Via Agency (Wakala) 74
4.2.1.7 Partnership 74
4.2.2 Phase 2: Growth and Stability (Seventh-Tenth Century) 75
4.2.3 Phase 3: Decline (Tenth-Thirteenth Century) 78
4.2.4 Phase 4: Partial Growth (Thirteenth-Sixteenth Century) 78
4.3 Conclusion 82
Chapter 5: A Historical Analysis of Financial Innovation in Islamic Economics and Finance from the Sixteenth Century to Present 83
5.1 Introduction 83
5.2 Phase Five: Youthfulness (Sixteenth to Nineteenth Century) 83
5.3 Phase Six: The Decline of the Ottoman State and Subservience to the West (from the Beginning of the Nineteenth Century to ... 86
5.4 Phase Seven: Islamic Finance Revivalism (1950s-1960s) 88
5.5 Phase Eight: Interest-Free Islamic Banking (1970s-Present) 91
5.5.1 Emergence of Islamic Banking 92
5.5.2 An Empirical Account on Islamic Banking in the West 95
5.5.2.1 Islamic Banking in Western Europe 95
5.5.2.2 Islamic Banking in the United States of America 98
5.5.3 Evolution of Islamic Banking in South East Asia, Pakistan and Iran 99
5.5.3.1 Malaysia 99
5.5.3.2 Indonesia 100
5.5.3.3 Thailand 100
5.5.3.4 Brunei 101
5.5.3.5 Pakistan 101
5.5.3.6 Iran 102
5.5.4 Various Approaches to Shariah Governance 102
5.5.4.1 Proactive Approach to Shariah Governance 103
5.5.4.2 Reactive Approach to Shariah Governance 103
5.5.4.3 A Hybrid Approach of Proactive and Reactive Approaches to Shariah Governance 103
5.6 Conclusion 104
Chapter 6: Traditional Theory of Financial Innovation 108
6.1 Introduction 108
6.2 Analysis of the Role Played by Financial Innovation in Creating Financial Crises 109
6.3 Fundamental Elements Influencing the Financial Market 110
6.4 The Resilience of the Banking System: A Key Factor in the On-Going Financial Crises 110
6.5 The Race by Financial Institutions to Develop Sophisticated Financial Products 111
6.6 The Root Cause of Financial Crises 112
6.7 What Is Financial Innovation? 113
6.7.1 Financial Innovation in History 114
6.7.2 What Drives Financial Innovation? 115
6.8 Undesirable Consequences of Innovation 115
6.9 Pro-Innovation Bias 117
6.10 Three Schools of Innovation 118
6.10.1 The Corporate Entrepreneurial School: A Social Perspective-Innovation as Grassroots Impetuses 119
6.10.2 The Cultural School: A Cultural Perspective-Nature of Innovation: Deep Craft 120
6.10.3 The Capability School: An Economic Perspective-Innovation as Institutionalised Capability 120
6.11 Conclusion 122
Chapter 7: Financial Innovation Theory from an Islamic Perspective 124
7.1 Introduction 124
7.2 Four Schools of Innovation 125
7.3 Definition of Innovation from an Islamic Perspective 126
7.4 The Islamic School of Financial Innovation 126
7.5 The Mechanics of Financial Innovation: The Role of Jurisprudence 127
7.6 The Application of Normativity Through Social Practices: Bourdieu´s Theory 128
7.7 Socially Useless Financial Innovation 131
7.8 Economic Thought in the Qura´an and the Sunnah, Basic Philosophy for Financial Innovation Theory 132
7.8.1 The Concept of Unity, Tawhid 132
7.8.2 The Concept of Vicegerency, al Khilafah 134
7.8.3 The Concept of Free Will and Responsibility, al-Iradah wa al-Masu´wliyyah 135
7.8.3.1 Free Will and Trust (Amanah) 135
7.8.3.2 Responsibility 135
7.8.3.3 A System of Reward and Punishment 136
7.9 Islamic Economic Principles: The Fundamentals for an Islamic Theory of Innovation 136
7.9.1 The Principle of Moderation (I´atidal) in Financial Innovation 136
7.9.2 The Principle of Economic Efficiency in Financial Innovation 137
7.9.3 The Principle of Social Justice (al-A´adalah al-Ijtima´iyyah) in Financial Innovation 139
7.10 Application of the Basic Islamic Philosophy in Financial Innovation 140
7.11 The Origins of Shariah Supervision and Governance 140
7.12 Conclusion 142
Chapter 8: Futures Contracts as an Underlying Product of Financial Engineering in Islamic Finance 144
8.1 Introduction 144
8.2 Definition of Futures 145
8.3 Financial Futures 146
8.4 Hedging Mechanism Through Derivatives 147
8.4.1 Objective of Hedging 147
8.4.2 Hedging Using Options 147
8.4.3 Hedging Interest-Rate Risk with Financial Futures 148
8.5 Futures from an Islamic Perspective 148
8.6 Problems Related to Futures Markets from an Islamic Finance Perspective 150
8.7 Al-Gharar (Uncertainty) in the Futures Market 150
8.8 Conclusion 151
Chapter 9: Options Contracts as an Underlying Product of Financial Engineering in Islamic Finance 152
9.1 Introduction 152
9.2 What Is an Option 152
9.3 A Brief Historical Review of Options 153
9.4 Types of Options 154
9.4.1 Call Option 154
9.4.2 Put Option 154
9.4.3 Double Options 155
9.5 Why Options Are Popular 155
9.6 Useful Economic Purposes Served by Options 155
9.7 Market Analysis of Options 156
9.8 An Assessment of Options from an Islamic Finance View 157
9.9 Options in the Islamic Literature 157
9.10 Some Possible Shar?´ah Objections to Options 158
9.11 Khiy?r as a Form of Option 158
9.11.1 Main Typical Types of al-khiy?r?t (Options) as Validated by the Sunnah 159
9.12 Options and Islamic Jurisprudence 159
9.12.1 Call Option 160
9.12.2 Put Option 161
9.12.3 Index Option 161
9.12.4 Right as an Object of Sale 161
9.13 The Framework of Khiy?r al-Shart and Dam?n (guarantee) 162
9.14 Similarity Between Options and Bai´ al-`Arbun (Down-Payment Sale) 165
9.15 Conclusion 166
Chapter 10: Outlining a Framework for Financial Innovation and Engineering in Islamic Finance 168
10.1 Introduction 168
10.2 Affiliated Risk with Options Contracts 169
10.3 Al-Gharar (Uncertainty) in the Option Market 169
10.4 The Issue of Riba (Usury) Associated with Options 170
10.5 The Rationale of Prohibiting Conventional Options 171
10.6 Muslim Economists Point of View 172
10.7 Options from usul al-Fiqh (The Sources of Law) Point of View 173
10.7.1 Istihs?n 173
10.7.2 Al-maslaha al-mursala (Common Good) 173
10.8 Financial Contracts with Embedded Khiy?r al-Shart 174
10.9 Managing Price Risk with khiy?r al-shart 175
10.10 Istijr?r Sale with Khiy?r al-Shart 176
10.11 Exclusions from Option Contracts 177
10.12 Conclusion 178
Chapter 11: Case Study: Analysis of Selected Shariah Compliant Financial Products 180
11.1 Introduction 180
11.2 Scope of the Documentary Analysis 181
11.3 Findings of the Case Study Through Documentary Analysis 182
11.3.1 Documentary Analysis of an Investment Product 182
11.3.1.1 Shariah Objectives 182
11.3.1.2 Social Welfare Impact 183
11.3.1.3 Suitability of the Selected Islamic Finance Principle or Structure 183
11.3.1.4 Compliance of the Structure with All Requirements of the Islamic Finance Principle Employed 183
11.3.1.5 A Shariah Compliant Product or a Shariah Inspired Product in Form and Substance 184
11.3.2 Documentary Analysis of a Home Finance Product 184
11.3.2.1 Shariah Objectives 185
11.3.2.2 Social Welfare Impact 185
11.3.2.3 Suitability of the Selected Islamic Finance Principle or Structure 185
11.3.2.4 Compliance of the Structure with All Requirements of the Islamic Finance Principle Employed 186
11.3.2.5 A Shariah Compliant Product or a Shariah Inspired Product in Form and Substance 187
11.3.3 Documentary Analysis of a Derivative Product 187
11.3.3.1 Shariah Objectives 187
11.3.3.2 Social Welfare Impact 188
11.3.3.3 Suitability of the Selected Islamic Finance Principle or Structure 188
11.3.3.4 Compliance of the Structure with All Requirements of the Islamic Finance Principle Employed 188
11.3.3.5 A Shariah Compliant Product or a Shariah Inspired Product in Form and Substance 189
11.3.4 Documentary Analysis of Sukuk (Equity Based Islamic Certificate) Issue 189
11.3.4.1 Shariah Objectives 190
11.3.4.2 Social Welfare Impact 190
11.3.4.3 Suitability of the Selected Islamic Finance Principle or Structure 191
11.3.4.4 Compliance of the Structure with All Requirements of the Islamic Finance Principle Employed 191
11.3.4.5 Shariah Compliant Product or a Shariah Inspired Product in Form and Substance 192
11.4 Summary of the Documentary Analysis Findings 192
11.5 Conclusion 192
Chapter 12: Discussion and Conclusion 194
12.1 Introduction 194
12.2 Discussion 194
12.3 Book Contribution 198
12.4 Policy Implications 199
12.5 Case Study of a New Shariah Compliant Financial Innovation (Takaful Student Finance) 201
12.5.1 Background of the Financial Innovation 201
12.5.2 The Analytical Process That Led to a Solution for the Alternative Student Finance 202
12.5.3 Takaful as a Solution for the Alternative Student Finance 203
12.6 Conclusion 205
12.7 Avenues for Future Research 208
Glossary 209
References 214
Index 234