Islamic Banking Resistance to Receivables Securitization

ABSTRACT

Receivables securitization is a vital financial instrument which has faced some resistance in the Islamic world -- with the exception of Malaysia - with the result that its role in Islamic finance is as yet underdeveloped. The reasons behind this resistance are relatively ambiguous, and have not been thoroughly explored, as the existing Islamic literature offers only touches on the topic on a superficial level. This study traces the roots of the concerns of Islamic academics, opens them up to thorough discussion and proposes an objective way forward.

While this study identifies three justifications behind the Islamic resistance to receivables securitization that relate to fiat money, gharar (risk), and usury, it could be argued that the key issue driving these objections is a misapplication of the Islamic rules governing gold and silver to fiat money. There is, however, a strong basis for arguing that fiat money is merely a ‘legal commodity' and should be regulated by the Islamic commodity rules, removing the obstacle to the use of receivable securitization.

Concerns regarding gharar (risk) and interest are valid but can be safely managed by developing an ethics-based form of securitization that protects against such risks as gambling or inability to deliver. In addition, securitization transactions could be structured on usury-free models.

Finally, an attention should be drawn to the methodology used by Islamic intellectuals to apply Islamic rules to contemporary concepts. Methodologies need to be re-examined to ensure that they are true to the spirit of Islamic teaching.

Introduction

While it is still a relatively new concept, securitization has become a vital and effective instrument for raising funds, boosting liquidity, managing risk and allocating capital efficiently. Nevertheless, in a world where consumption has become a way of life and gambling has been raised to the status of a profession or an art form, securitization poses a silent but real threat to economies.

The question has been raised as to whether or not securitization has played a role in the recent financial crisis.[1] It is argued that securitization encourages excessive borrowing, limits oversight by lenders and encourages dependence by borrowers, as well as creating what some call the "illusion of liquidity".[2] Undoubtedly, the provision of loans and securitization facilitates the realization of individuals' goals and creates investment opportunities. But due to the sensitivity of these tools, a disciplined and ethical environment is needed in order to protect against their misuse. This is, according to Hugo Bouleau, what is offered by the principles of Islamic finance[3]; indeed, Islam provides a comprehensive ethical way of life including commerce and investment.

Islamic financial system solidly links between real assets, profits and risks. A financial transaction which does not provide these linkages may fail in the Shari'ah compliance test. However, assessing compliance is not always as simple as it may appear. While the foundations of the Islamic financial system were laid centuries ago, there are still divergences in scholar views concerning details, which has created serious challenges and generated debate in terms of identifying and understanding the gaps in applying the foundations of Islamic Shari'ah on the contemporary concepts. This has slowed the process of formulating a definite Islamic regulatory framework for financial industry particularly in a purely capitalist world.

As one the most debatable issues under Islamic law; this study focuses on the Islamic regulatory framework of receivable securitization which is acknowledged by Shari'ah scholars and Islamic finance professionals as very important instrument, but at the same time as a critical and sensitive field.

The framework of Shari'ah compliant receivable securitization is not yet firmly established due to the novelty of many economic and financial concepts, the lack of the Shari'ah scholars consensus on understanding and accommodating contemporary aspects, and, arguably, the expanded application of sadd al-dhara'i approach which, generally, means banning any permissible activity if it might lead to impressible result, contrary to the Shari'ah maxim "the norm in regards transactions is that of permissibility" which simply means that, any transaction, in principal, is permissible until a contradiction to Shari'ah is proven. This dilemma has given rise to two major directions of thought with regard to an Islamic perspective on receivable securitization; one is originated in Malaysia and the other, generally speaking, representing the rest of the Islamic world.

As a result of these factors, receivable securitization is less developed in Islamic financial markets than in the conventional. In fact, individuals or institutions who seek to comply with Shari'ah rules can find themselves lost in a maze of contradicting views and fatwas (considered opinions of Shari'ah scholars). In response to this reality, this study provides an analytical examination of the status of Shari'ah compliant receivable securitization for the sake of identifying the roots of the gaps and challenges. After all, it is not a study specializing in Shari'ah but an academic and professional tracing, using a simple problem solving technique, of the realistic causes behind challenging receivable securitization under Islamic law. It is a vital step for a clear understanding of the problem toward proposing a rational way forward.

The study addresses these issues in three chapters. Chapter One, An introductory platform, establishes the significance of the research topic, reviews the existing literature and demonstrates the value added by this study. Chapter Two, General Background and key underlying concepts, provides an introduction to the concepts of receivable securitization as well as the Islamic financial system in order to assist the reader in engaging with the ideas presented. Chapter Three, the Islamic regulatory framework for receivable securitization, provides a conceptual introduction to Shari'ah compliant securitization, and examines the roots of causes that behind challenging of the receivables securitization under Islamic law, where Chapter Four, Proposal for a way forward, provides a global proposal for embracing an ethical and disciplined Islamic compliant receivables securitization.

Finally, the Conclusion summarizes the overall inputs and outputs of the study including its question and results.

Chapter One: AN INTRODUCTORY PLATFORM

1.1 Why it matters

Globalization is inescapable. The faiths, cultures and nations of the world are being gathered together into a single economy and trade pool. Despite the diversity of identities, economies are compelled to meet around the global table. At the end, the wisest strategy for any ideological group is to find a way to accommodate international developments while remaining true to its principles and convictions.

Islam is the second largest religion of the world, with its followers estimated at 21% of the world's population.[4] Muslim communities in historically non Muslim countries are growing rapidly. For instance, a 2001 census in the UK indicated a population of 1.591 million Muslims[5]. Although the next census will be in 2011, Richard Kerbaji reported that the growth of Muslim population is 10 times faster than that of other communities within the UK.[6]

Independent of radical trends, the significance of Islam as a major world religion and the impact of Muslims as a community within the global context have made Islamic considerations a top priority on political and economic agendas within the international arena. Likewise, the global Muslim community cannot afford to be passive but must rationally and objectively engage with global changes and challenges. In a lecture given in 1993, H.R.H. the Prince of Wales stressed the fact that:

" … The Islamic and Western world can no longer afford to stand apart from a common effort to solve their common problems… We have to share experiences, to explain ourselves to each other".[7]

This is, indeed, the reality of where we find ourselves today. And while interaction between civilizations and national and international factors is unavoidable, fundamental beliefs and inviolable principles will continue to exist which must be understood and respected.

From finance perspective, while exact s are not available, broad agreement does exist that the size of the wealth and assets and the wide range of business networks of Muslims, both in Islamic countries and in the rest of the world, is significant. The demand for financial services which comply with Islamic law can be expected to increase tremendously, particularly following the recent global recession. It is estimated that there will be about 15 - 20 % annual growth in the Islamic financial products, with equity fund assets climbing to US $53 billion by 2010.[8]

It is clear that a direct correlation exists: whenever the demand for banking products increases, banking debts multiply. This heightens credit risk and threatens the availability of capital and liquidity. Basel II, which represents the international consensus on capital standards, embraces securitization as an effective and helpful tool in this regard.[9] However, unless Muslim intellectuals invest considerable energy in developing clear and reliable regulatory frameworks which comply with Islamic law for the newborn concepts including securitization, Islamic banks will continue to experience difficulties in the areas of liquidity and risk management, and will fail to meet the requirements for international convergence.

From another angle, the recent global economic crisis has exposed the fragility of capitalist economics. According to Sam Whimster “[c]apitalism itself is without morality…The finance capitalism of today has some startlingly irrational features and is no longer led by those who possess the requisite moral probity”.[10] As the need for more disciplined and ethical systems becomes increasingly apparent, the potential of Islamic finance as an alternative to conventional finance is gaining attention. As a result, broader awareness is developing in the international community regarding the features of Islamic finance and securitization. Toby Birch comments that the Islamic principles established by a desert-dwelling Bedouin fourteen hundred years ago embody the timeless wisdom which holds the key to the financial crises of today.[11]

The recognition of the advantages of Islamic financial systems on objective and professional terms by non Muslim experts places a serious responsibility on Muslims experts and researchers to address and resolve the internal challenges which currently impede the development of Shari'ah compliant products, including receivable securitization.

1.2 Literature review

It could be stated that a wealth of studies on Islamic finance can be found in libraries and on the online resources. In addition, Arabic and English literature typically have many publications on securitization within its conventional sense. However, studies focussing specifically on Shari'ah compliant receivable securitization, and its underlying challenges, are, noticeably few.

The works which have, in fact, played the greatest role in shaping the dominant Islamic view on receivable securitization, are the many working papers that have been submitted at Islamic scholarly forums and conferences, particularly the annual conferences of the International Islamic Fiqh Academy, and the Islamic Fiqh Academy of Muslim World League. For instance, at its 19th conference in April 2009, the International Islamic Fiqh Academy discussed a group of working papers specifically focussing on, or closely related to, receivable securitization. However, by and large, the structures and approach of the papers were virtually identical, which is to be expected as the authors shared the same perspective on the same issue.

In terms of its significance, securitization represents one of the most important innovations in the finance sector. It is, as Leon Kendall puts it, “changing the face of American and world of finance”.[12] This view is shared by many experts in the field, who see securitization as an essential component of the modern financial system. Vinod Kothari makes an identical statement to that of Kendall, and suggests that securitization is more than funding instrument that works beyond financial limitations.[13] This admiration for securitization can be attributed to the advantages which, according to Charles Ston and Anne Zissu, provides in alleviating balance sheet pressure,[14] transferring and fragmentizing credit risk, raising capital and securing liquidity.

The importance of securitization is recognized by Islamic Intellectuals. AbdulBari Musha'al points out that receivable securitization is an important instrument in that it provides lenders rapid turnaround on their capital in order to re-inject it into investment and production operations.[15] Fuad Muhaisen identifies nine advantages provided by securitization, including its role in funding and financing privatization projects.[16] Furthermore, the working papers mentioned above which were submitted at the 19th conference of International Islamic Fiqh Academy demonstrate a common acknowledgment of the importance of receivable securitization in the Islamic world.

Despite the worldwide recognition of the importance of securitization, another side of it could be recognized. Lawis Ranieri describes securitization as an adventure that involves a dark side, observing that it has contributed to destabilizing the thrift system and industry.[17] This represents one factor in the argument that securitization has been a contributing factor in the global credit crash. Thrift and credit are connected while they are also key components in the greater economic system. Securitization arguably promotes excessive credit creation,[18] encourages a culture of consumerism, and has contributed to the global financial crisis. Niall Ferguson argues that the crisis was caused by the rise and fall of "securitized loans".[19] While this assertion deserves consideration, it is possible that it was not securitization but the absence of the ethics that rationalize its use, which was the problem.

Islamic finance principles offer a framework with the capacity to fill this void. In his book ‘Islamic Finance Standards: Solving the Global Financial Crisis', Samir Kantaji provides a practical analysis of the global crisis and suggests that Islamic principles of finance provide the ethical and disciplined environment necessary to prevent such a future financial crash.[20]

While the principles of Islamic finance were established more than fourteen hundred years ago, they do offer, as implied by Hugo Bouleau, solutions to today's banking problems.[21] The question, however, is whether Shari'ah scholars have the flexibility to apply these principles meaningfully to contemporary financial concepts, in general, and to securitization, in particular.

The dominant philosophy of Shari'ah scholars is sadd al-dhara'i (banning any permissible activity if it might lead to an impressible result). This approach has been stressed by the International Islamic Fiqh Academy in its Resolution No. 92 (9/9), issued in April 1995.[22] However, many Islamic intellectuals oppose broadening the application of sadd al-dhara'i. Akhtar Zaiti emphasizes the contrasting Shari'ah maxim, “the norm in regards transactions in that of permissibility”, and the fact that the financial principles, maxims and frameworks provided by the Quran and Sunnah are not detailed because the finance industry and human interests vary over time. She argues that Muslims should be guided by this principle of permissibility as they engage with evolving financial concepts, including securitization, except in cases which present an obvious contradiction with the Quran and Sunna.[23]

Similarly, Fuad Muhaisen argues that Islam clearly identifies which activities are prohibited, leaving room for innovation and development over the course of time, and that this is how contemporary financial concepts should be approached.[24] Regardless of the argument, what is certain is that the convictions of some Shari'ah scholars, coupled with the rapid development of finance and economic concepts and the impossibility of accurately foreseeing all of their potential implications, impede the development of Islamic financial systems.

Studies addressing Shari'ah compliant receivable securitization typically roam around avoidance of Riba (usury) and Gharar (Risk), issues which are subdivided into more focused points such as profit-risk share, tangible asset connection and other underlying sub-issues. However, sale of loan is considered the cornerstone of employing receivable securitization, and is the subject of vigorous debate by Islamic intellectuals.

Sale of loan was a topic of discussion at the 1998 International Islamic Fiqh Academy conference. The conference concluded that the sale of loan to a third party, whether at a current or deferred price, is strictly prohibited in Islam because it leads to Riba (usury).[25] But at its 2006 conference, International Islamic Fiqh Academy demonstrated greater flexibility and determined four permissible models for sale of Loan,[26] A similar resolution was issued by Islamic Fiqh Academy of MWL at its 2002 conference stating that some sale of loan models are prohibited because they lead to riba (usury) or Gharar (risk) of the inability of delivery, accordingly, receivable securitization is prohibited.[27] It should be noticed that loan in Islam could be goods, services, usufructs or receivables (cash flow), but none of the mentioned resolutions accepted the sale or securitization of receivables.

There is no consensus regarding the prohibition of sale of loan. For example, in his book ‘The theory of loan in Islamic fiqh' Ahmed Al-Hajj discusses the different viewpoints supporting and opposing sale of loan and concludes that it is permissible provided that delivery of the sale (repayment of the loan) is not possible[28]. This approach has been embraced by the Malaysian Securities Commission Shariah Advisory Council since 1996 which opened the door wide to receivable securitization in this Islamic country[29], which is, according to Rashid Al-Khan, has been widely criticized by many Middle Eastern scholars.[30] Furthermore, Saiful Rosly and Mahmood Sanusi point out that trading of Islamic bond structured on a sale of loan basis in Malaysia has been found impermissible by the majority of Shari'ah scholars.[31]

Apparently, there is a clear disagreement over the key issues involved in achieving effective Shari'ah compliant receivable securitization. However, this does not mean that Shari'ah compliant receivable securitization cannot be utilized until the dilemma is resolved. Nor does it mean that the current position of Shari'ah scholars is final. The possibility always exists of renegotiating the interfaces that are developed between Shari'ah and developing technical concepts.

The literature already includes a number of publications which discuss the foundational concepts of Islamic finance and attempt to develop an Islamic framework for securitization which brings together Islamic principles and finance innovation. But gaps remain in terms of scope and approaches of studies. To put differently, the existing Islamic literature offers only a superficial and indirect exploration of the reasons for which the permissibility of receivable securitization has been challenged under Islamic law, and handles this discussion within previous immature viewpoints.

1.3 Scope and significance of the study

This study provides a panoramic view of the current situation of receivable securitization within the Islamic law. It discusses the dominant Islamic intellectuals' approach that banes it, and tackles the question of what are the realistic reasons of challenging receivables securitization under Islamic law.

In order to add value, this study is a digging deeper into the roots of the argument. Using a simple problem solving techniques, it traces those roots to out what is, precisely, reason behind the resistance of Shari'ah scholar to accepting receivables securitization. Differently, this study openly discusses the issues, and it is completely built of the maxim that in principal, any transaction is permissible until a contradiction to Shari'ah is proven. Furthermore, the study reflects rational viewpoint regarding riba (usury) concept which has been unreasonably exaggerated over the time.

Notwithstanding, this study must not be read as a revolt against any of the Islamic schools of thought or organizations, but an objective attempt to re-pull the attention to realistic causes of prohibition of receivables securitization under Islamic law.

Overall, this study helps to identify areas where religious perspectives and technical practice do not yet interface with regard to receivable securitization, and spells out the reforms needed to the approach of Islamic intellectuals' methodology in terms of Islamic financing in general and securitization in particular.