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ISLAMIC WEALTH MANAGEMENT AND ITS RELEVANCEIN MODERN TIMES
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Shamsher Mohamad Ramadili Mohd
ISLAMIC WEALTH MANAGEMENT AND ITS RELEVANCEIN MODERN TIMES
17PG
Research HighlightsThe New Realities
of Risk Sharing Network Effects
and Big Data Machine Learning
Ginanjar Dewandaru, Adam Ng, Abbas Mirakhor
2PG
From the Research PipelineIncome Inequality
Reduction through alternative financial
institutions to RibaMagda Ismail
PP18986/07/2017(034546)ISSN 0127-9998ISSUE 05 JUNE 2017
In Person
Editor-in-Chief Assoc Prof Dr Baharom Abdul Hamid
Director, Research Management Centre
Editor Asst Prof Dr Adam Ng
Deputy Director, Research Management Centre
Coordinating Producer Ms Wiaam Hassan
Senior Research Executive [email protected]
Coordinating Designer Mr Ahmad Fahmi Jelani
([email protected]) Ms Normas Rafie
IF Hub Liaison Officer Ms Rita Norzizana Mohd Noor
Programme Executive [email protected]
Mr Muhamad Fairuz Fuad Admin Assistant [email protected]
Published by: International Centre for
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PP 18986/07/2016(034546) | ISSN 0127-9998
Quarterly Publication
5th Edition 2017TABLE OF CONTENTS1. Editor’s Note VI
3. In Person Islamic Wealth Management and Its RelevanceIn Modern TimesShamsher Mohamad Ramadili Mohd & Ziyaad Mahomed
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2. From The Research Pipeline Income Inequality Reduction Through Alternative Financial Institutions To Riba (An Islamic Approach)By Assoc. Prof. Dr Magda Ismail (UM-INCEIF Collaboration)
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4. Research Highlights The New Realities of Risk Sharing: Network Effects and Big Data Machine LearningBy Ginanjar Dewandaru, Adam Ng, Abbas Mirakhor
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5. The Future Leadersi) The impact of competition on banks efficiency Do business model and corporate governance matter:
evidence from dual banking systems By: Kinan Salim (PhD, Candidate), Mansor H. Ibrahim
(INCEIF), Baharom Abdul Hamid (INCEIF)ii) On the Dynamic Links Between Commodities and Islamic
Equity By: Ruslan Nagayev, Mustafa Disli, Koen Inghelbrecht, Adam Ng
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8. Ad SpaceStudent Intake 2018
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INCEIF Endowment Fund (IEF)
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Three Minute Thesis Competition
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3rd Annual Symposium on Islamic Finance 2017
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INCEIF Knowledge Repository (IKR)
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337. INCEIF Knowledge Indicator
326. Knowledge Management Centre (KMC) HighlightsIKR Faculty Dashboard
DATO’ DR AZMI OMARCOMES ONBOARD
INCEIF welcomes Dato’ Dr. Azmi Omar as the new President & Chief Executive Officer (PCEO). He takes over from Mr Daud Vicary Abdullah, INCEIF’s second PCEO, who retired in July.
Dato’ Azmi’s previous post was as the Director General for Islamic Research and Training Institute (IRTI), Islamic Development Bank (IDB), Jeddah. IRTI was established in 1981 with the principal aim to undertake research, training and advisory activities in Islamic economics and Islamic finance, and to facilitate the economic, financial and banking activities in IDB member countries to
conform to Shariah.
Prior to IDB, Dato’ Azmi was the Dean of the IIUM Institute of Islamic Banking and Finance as well as a Professor at the Department of Finance, Faculty of Economics & Management Sciences, International Islamic University Malaysia (IIUM). He was the former Deputy Rector (Deputy Vice- Chancellor) in charge of Academic and Research from 2002 until 2008. He has also served as the Dean of the Faculty of Economics & Management Sciences at the same university from 1996 to early 2002. He was formerly the Shariah adviser to Bank Kerjasama Rakyat Malaysia Berhad and Amanah Ikhtiar Malaysia.
He obtained his Bachelor and Master degrees in Finance from Northern Illinois University, USA and PhD from Bangor University, Wales (UK). In a statement, Dato’
Azmi said: “I look forward to the challenges this new role brings and hope to continue the work laid by my predecessors. With the support of Bank Negara
Malaysia and the industry, INCEIF will continuously push and expand the frontiers of Islamic finance knowledge in both the national and international
sphere.
“Although the Islamic finance industry is growing in terms of breadth and depth, there are still hurdles in making it mainstream. As a global
university, INCEIF hopes to contribute towards the development of the industry by developing talent and making an impact through
research especially in the area of applied research that is solution-driven and industry-related. “Together with the students,
faculty members, staff and other stakeholders, I hope that we can make an indelible mark on the industry, a mark that will be
the catalyst of appreciation for all the ethical tenets that Islamic finance advocates,” Dato’ Azmi added.
INCEIF was set up by Bank Negara Malaysia in 2005 to develop human capital and knowledge leadership for
the global Islamic finance industry. In its 11th year of operation, INCEIF remains the only university in
the world to focus solely on postgraduate studies in Islamic finance. As a result, the
university has attracted partners from all over the world who showed interest in tapping into
its pool of Islamic finance experts. Among them are International Federation of Red Cross and
Red Crescent Societies, Geneva; Capital Market Development Authority, Maldives; and
University of Reading in Malaysia.
EDITOR’S NOTE
“The New Realities of Risk Sharing: Network Effects and Big Data Machine Learning” is written by Dr Ginanjar Dewandaru. Quite intriguing and thought provoking on the realities of the current affairs and state of the financial world. From the young scholars corner we have two refreshing articles, the first is from Dr Kinan Salim, the article that was nominated as one of the best papers during the IFFBBE 2017, titled “The Impact of Competition on Banks Efficiency. Do business Model and Corporate Governance Matter: Evidence From Dual Banking Systems”. Secondly we have the article from the recipient of Young Research Award 2016, Dr Ruslan Nagayev titled “On The Dynamic Links Between Commodities and Islamic Equity “.
We aspire for IF HUB to be the most efficient way to share and showcase what we do best, to share our best ideas, tools as well as practices with regard to Islamic Finance.
Again we would like to stress, moving forward, it is the aspiration of INCEIF, to be the reference point and knowledge leaders of Islamic Finance not only in the region but globally.
Last but not least my gratitude for all the players who have played a key role in making this issue of IF HUB a reality, both directly and indirectly.
Feedbacks and comments are most welcome.
We aspire for IF HUB to be the most efficient way to share and showcase what we do best, to share our best ideas, tools as well as practices with regard to Islamic Finance.
Assalamualaikum wbt,
Alhamdulillah! IF HUB continues to garner positive feedback.
In this second issue of 2017, we placed a special focus on wealth management. The highlight of this issue is the article by Prof Shamsher in whereby he writes about the unique dispensation on the concept of wealth, its ownership and distribution. He reiterates that wealth is not regarded as an end per se, but a means to an end: the end being the paradise in the hereafter. Beautifully written and aptly titled “Islamic Wealth Management and Its Relevance in ModernTimes”. From the research pipeline section, we have another interesting article by Dr Magda on Income Inequality Reduction through Alternative Financial Institutions to Riba (An Islamic Approach). This article originates from the research grant provided by INCEIF-UM Research. She argues on the believe of some economists that the main cause of this income inequalities is due to the unjust financial system which is based on Riba and offers a provide solution to this problem.
Assoc. Prof. Dr Baharom Abdul Hamid
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Income Inequality Reduction
1. World Bank Statistics (2010): http://www.globalissues.org/article/26/poverty-facts-and-stats.
2. Oxfam report (2015): https://www.weforum.org/agenda/2016/01/3-charts-that-explain-global-inequality/
3. Wolff, R. D. (2010). Capitalism hits the fan: The global economic meltdown and what to do about it. Northampton, Mass: Olive Branch Press.
4. Van Saten, Rieneke M. (2010), Microfinance as a Poverty Reduction Policy, view at: http://www.microfinancegateway.org/gm/
document1.9.44607/Microfinance%20as%20a%20Poverty%20Reduction%20Policy.pdf
5. Turner, A. (2017). Between Debt and the Devil: Money, Credit, and Fixing GlobalFinance, Princeton: Princeton University Press
6. Thomas Piketty (2013). Capital in the twenty-First Century, translated by Arthur Goldhammer, Harvard College USA.
7. WDR 2000/2001:https://openknowledge.worldbank.org/bitstream/handle/10986/11856/9780195211290_ch07.pdf?sequence=13
By: Magda Ismail Abdel Mohsin (INCEIF)*This research project is funded through INCEIF-UM Research Collaboration Fund
CURRENT SCENARIO ON INCOME INEQUALITY
According to the World Bank Statistics (2012) more than 80% of the world’s population live in countries where income inequality is very wide.The
latest Oxfam report shows that the richest 1% of the world population holds over 50% of the world’s wealth. This means that 62 richest people own an estimated wealth of US$1.76 trillion which is equivalent to the wealth of 3.5 billion people who make the poorest half of the world population (2015). The failure of the capitalist system in reducing this income inequality encourages economists to provide justification for this huge gap between the rich and the poor.Some economists believe that the main causes of this income inequalities is due to the unjust financial system which is based on interest/Riba while others tried to provide solution to this problem.
For example according to Wolff, R. D. (2010)the current global crisis persists as a result of the capitalism system in financing with interest.He provides evidence showing that the current financial crisis started in early 1970s as a result of the introduction of technology and the
THROUGH ALTERNATIVE FINANCIAL INSTITUTIONS TO RIBA (AN ISLAMIC APPROACH)
This means that 62 richest people own an estimated wealth of $1.76 trillion which is equivalent to the wealth of 3.5 billion people who make the poorest half of the world population (2015).
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increment ofthe employers’ profit to the extent that they deposited it in banks to be lend to the employees whose wages remained stagnant.This act continued to widen the gap between the employers and the employees since the later have to repay the loan with interest. Similarly and according to Van Saten (2010) he realised that financing with interest does not stopped only in financing the employees but it extended to the financing of the anti-poverty and microfinance programmes- a matter which again resulted in a wide gap between the rich and the poor.
On the other hand to solve the problem of inequalities, Turner A. (2017) suggested to abolish banks and to call for an economy without banks calling it the Strange Amnesia of Modern Macroeconomics. Moreover, Piketty (2013) proposed a redistribution system through a progressive global tax on wealth.The World Development Report (WDR 2000/2001) devoted a whole chapter on explaining how removing social barriers and building social institutions could help in reducing income inequality.
From the above, it seems that one of the main causes of this income inequality is the current Mono-Financial System that finances with interest. This will bring the following questions; if this interest-based system is the main cause for this huge gap between the rich and the poor, then what are the other alternatives? This will be answered below:
INCOME INEQUALITY REDUCTION: AN ISLAMIC APPROACHIslam is not just a religion of worship. It is a comprehensive discipline that includes all aspects of sciences including economics. It provides many institutions that have to function in parallel in order to enhance a just and a welfare society for all. The current global financial crises urge Muslim economists to revive the alternative financial institution(s) to Riba/interest-based institution which is prohibited in Islam.
In Islam, removing social barriers and building social institutions is much recommended since all human beings are equal and constitute one single community.This is reflected very clearly in the following hadith of the Prophet (PBUH) whereby there is no difference between man and man due to race, colour, country or language with the exception of piety and good action, hence all human being deserve to be treated in a fair and just ways.
The Prophet (PBUH) Said:
On the other hand to solve the problem of inequalities, Turner A. (2017)suggested to abolish banks and to call for an economy without banks calling it the Strange Amnesia of Modern Macroeconomics.
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All mankind is from Adam and Eve, an Arab has no superiority over a non-Arab nor a non-Arab has any superiority over an Arab; also a white has no superiority over a black nor a black has any superiority over white except by piety and good action.
The main objective of this paper is to present the alternative financial institutions to Riba –based institution together with their financial products showing how each can narrow the gap between the rich and the poor in a fair and just way.
ALTERNATIVE FINANCIAL INSTITUTIONS TO RIBA & THEIR FINANCIAL PRODUCTS Since Riba is prohibited in Islam, Islam provides four alternative financial institutions to Riba for economic activities as well as for social activities namely:bai‘/trade financial institution, lending through qard-hassan financial institution, compulsory/zakah financial institution and voluntary/sadaqah financial institutions (Abdel Mohsin 2011) .
a) Bai‘/Trade Financial Institution Bai‘/trade is one of the alternative financial institutions to Riba, as mentioned in the following Quranic verse, in order to handle the business activities in a fair and just manner between all parties involved in such business.
Allah hath permitted trade and forbidden usury…..(Surat al-Baqarah 2: 276)
Even though under trade financial institution there are many financial products yet, this paper focuses only on five financial products namely Musharakah, Mudarabah, Murabahah, Ijarah and Sukuk as presented in Figure (1).For all these financial products the risk will be spread between the owner(s) of the capital and the entrepreneur(s) depending on the financial product used and there will be no room for one party profiting over the other.
b) Al-Qard Al-Hassan/Benevolent Loan Financial Institution
Al-Qard al-Hassan is an interest-free financial institution to give loans but without Riba. This is the only lending institution which is allowed in Islam in order to assist one’s brother to find a living. Since it is more to help others who are in crucial need, the lender must not expect any additional return over the capital but should seek multiple rewards from His Creator as mentioned
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1. Abdel Mohsin Magda (2011). “x of Zakah and Waqf as community empowerment for economic transformation of Muslim societies”, in: the Life-3 INSANIAH International Conference Islamic Finance and Economic, organized by INSANIAH & IRTI, Langhawi, 28-31 October 2011.
BAI‘/ TRADE FINANCIAL INSTITUTION
· Salam, · Mua’jjal, · Istisna’, · Ijarah, · Murabahah li
al’amer bi al shira’ · Musharakah
Mutanaqisah.
Ijarah/ Leasing Sukuk/BondMurabahahMark-up Principle
MudarabahProfit Sharing Principle
Musharakah/Partnership
Profit and Loss Sharing
Figure (1) Al-Bai‘/ trade financial institutions for economic activities.
in the following Quranic verse:
Who is he that will loan to God a beautiful loan, which God will double unto his credit and multiply many times? (Surat al-Baqarah 2:245)
Hence, this will help the borrower to repay only the borrowed amount without burdening him with the payment of any additional amount.
c) Zakat Financial InstitutionZakat financial institution is also one of the alternative financial institutions to Riba as mentioned in the following Quranic verse:
“And that which you give in gift (to others), in other that it may increase (your wealth by expecting to get a better one in return) from other people’s property, has no increase with Allah; but that which you give in Zakat seeking Allah’s Countenance, then those they shall have manifold increase.” (Surat al-Rum, 30:39)
Hence, zakah is a compulsory due to be collected from all eligible Muslims and from all types of wealth and to be redistributed to eight zakah recipients, as highlighted in the following Quranic verse;
“Zakat is for the poor, and the needy and those who are employed to administer and collect it, and the
new converts, and for those who are in bondage, and in debt and service of the cause of Allah, and for the wayfarers, a duty ordained by Allah, and Allah is the All-Knowing, the Wise” (Surah al-Tauba, 9:60)
The distribution can be done through establishing eight financial products, each according to its zakat recipients as shown in Figure (2).
As explained above through supporting these eight recipients with zakat money, this will improve their situation and will empower them to be zakat givers rather than zakat receivers hence it reduces the gap between the rich and the poor.
d) Sadaqah Financial InstitutionsSadaqah financial institutions are voluntary in nature and they are also alternative financial institutions to Riba as mentioned in the following Quranic verse:
Allah will deprive usury of all blessing, but will give increase for deeds of charity…(Surat al-Baqarah 2:276)
Both Muslims and non-Muslims living in an Muslim country have to fulfil their responsibilities in contributing voluntarily to their society. This voluntary financial institution includes sadaqah & sadaqah Jariah/waqf financial institutions, as seen in Figure (3). They are meant to generate funds from many financial products in order to
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provide the different goods and services needed in the different societies without burdening governments and forcing them to borrow with interest for economic development projects.
Sadaqah is a voluntary act of giving alms for the cause of Allah or fisabillilah by individuals who want to contribute more than the compulsory due. There are two types of Sadaqah Financial Products:
• General Sadaqah Financial ProductGeneral Sadaqah is a type of charity financial product which can be given openly either in cash
or in kind to individuals or group of people who are financially in a difficult situation e.g. people facing natural disasters or lacking some goods and services in some villages. The main objective of this sadaqah financial product is to finance these categories of people rather than forcing them to borrow with interest when they are in crucial needs of the capital.
• Specific Sadaqah Financial ProductSpecific Sadaqah is a type of hidden charity to be given in secret to relatives, friends or neighbours in situation where they face sudden and crucial needs. The main objective of this hidden sadaqah
ZAKAT FINANCIAL INSTITUTION (A COMPULSORY SOCIO-FINANCIAL INSTITUTION)
Faqir Financial Product Miskeen Financial Product
‘Amil Financial Product Muallafah Qulubuhm Financial Product
Fiar-Riqab Financial Product Gharimin Financial Product
Fisabillillah Financial Product Ibnus Sabil Financial Product
Figure (2) Zakat financial institution for social activities.
Figure (3) Sadaqah financial institutions for social activities.
SADAQAH FINANCIAL INSTITUTION (VOLUNTARY SOCIO-FINANCIAL INSTITUTIONS)
SADAQAH FINANCIAL INSTITUTION
Waqf Financial Product for Community Services
Waqf Financial Product for Agriculture Sector
Waqf Financial Product for Business Activities
Waqf Financial Product for Industrial Sector
General Sadaqah Financial Product
Specific Sadaqah Financial Product
WAQF FINANCIAL INSTITUTION
is to prevent these people from borrowing with interest when they are in this crucial situation.
e) Waqf Financial Institution Waqf is another voluntary institution which is strongly recommended in Islam as mentioned in the following Quranic verse:
“By no means shall ye attain righteousness unless ye give (freely) of that which ye love” (Surah Al-i-Imran 3:92)
This waqf financial institution finances perpetual goods and services needed in every society, besides providing continuous rewards to its
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founder as mentioned by the Prophet (PBUH) in his following hadith;
The Prophet (s) said: When a man dies his acts come to an end, except three things, recurring charity, knowledge (by which people benefit), and pious offspring, who pray for him.
The beauty of this institution is that once a property is created as waqf it becomes perpetual, explicitly it must not be sold or inherited or given away as a gift.This will ensure continual supply of different goods and services within the society for many generations to come without burdening the government or resorting to borrowing with interest to provide such services. Even though there are many waqf financial products yet, in this paper the focus will be only on four financial products (Ismail, 2013)
Waqf Financial Product for Community ServicesThis voluntary financial product finances buildings which is most needed in each society such building schools, colleges, universities, hospitals, clinics, orphanages houses etc, hence openingjobs for the majority of people besides, providing the goods and the services needed in each society in a just manner.
Waqf Financial Product for Business Activities Similarly, this voluntary financial product finances commercial buildings such as offices, stores, bakeries, butcheries, pharmacies, goldsmiths, restaurants, stables, tailors, shoemakers, carpenters, money changers, hotels, baths etc. Equally opening jobs for the majority of people besides providing the goods and the services needed in each society in a just manner.
Waqf Financial Product for Agriculture SectorAgain, this voluntary financial product finances the agricultural sector hence feeding the masses besides opening jobs for the majority of farmers in a just manner.
The beauty of this institution is that once a property is created as waqf it becomes perpetual, explicitly it must not be sold or inherited or given away as a gift. This will ensure continual supply of different goods and services within the society for many generations to come without burdening the government or resorting to borrowing with interest to provide such services.Even though there are many waqf financial products, yet in this paper the focus will be only on four financial products.
1. Sahih Muslim, narrated by Abu Hurraira, No. 16312. Ismail, M. (2013). Towards understanding the structure of Islamic economic system in solving the current economics and financial crisis.
Journal of Business and Economics, 4 (4).
Waqf Financial Product for Industrial Sector Likewise, this voluntary financial product finances the buildings of different factories which is needed by the different societies. Again this financial product provides jobs for the majority of people besides providing the goods and the services needed in each society in a just manner.
As presented above, Islam provides many alternative financial institutions to Riba together with their financial products. All these financial institutions are meant to finance not only the different categories of people within a society but to finance all sectors at large in just ways. Hence, we believe that if all these alternative financial institutions are practiced today, it will not only eliminate dealing with Riba from the different societies but will reduce the gap between the rich and the poor in an equitable and just way.
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ISLAMIC WEALTH
MANAGEMENT AND ITS
RELEVANCE IN MODERN TIMES
By Shamsher Mohamad & Ziyaad Mahomed (INCEIF)
INTRODUCTION
Islam has a unique dispensation on the concept of wealth, its ownership and distribution. Wealth is not regarded as an end per se, but a means to an end: the end being the
paradise in the hereafter. Essentially, material possessions are considered the primary form of wealth, perceived to be generated, accumulated and/or invested by the one who acquired it. Inclusively, wisdom, knowledge, salvation and even contentment can all be categorized as wealth. From the Islamic perspective, Allah (to Him be Praise) is the true owner of all wealth and He entrusts it to man for beneficial use (Quran 20:6). Therefore, a Muslim is required to earn and invest wealth in Islamically permissible methods in the real sector of the economy. Investing accumulated wealth is indeed compulsory to facilitate further growth because hoarding of wealth is prohibited. He is also required to spend for the benefit of the society as a whole, as a
means to earn Allah’s pleasure and attain success (falaah) in the hereafter as well.
Islam frowns upon the excessive accumulation of wealth that arises from its coveting, realised from greed and often earned from unjust means. To avoid the avarice and inequitable distribution of wealth, Islam has created the institution of charity or zakat. This reduces the concentration of wealth in the hands of a few (a hallmark of the capitalist system). Zakat provides for the needy and fosters a more just and harmonious society. Zakat – and traditional social welfare systems – have achieved success in poverty alleviation but are susceptible to self-seeking parties that abuse the system.
From the Islamic perspective, wealth is a means to living a wholesome, productive and beneficial existence. Various members of society have rights to wealth arising from lawful earnings, family needs, inheritance, societal benefits and welfare. The Prophet (PBUH) declared that the guidelines for managing wealth from the Islamic perspective is explicitly explained in the Quran
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The main objective of this sadaqh financial product is to finance these categories of people rather than forcing them to borrow with interest when they are in crucial needs of the capital.
in extravagance (Quran 7:31); Al Tabzeer or spending on prohibited items (Quran 17:27); Kanzul Maal or hoarding of wealth for the love of it.
In mainstream economics, wealth is defined by quantitative measurements of one’s material possessions. In the parlance of modern economics, wealth is defined as the owners’ potential capital that is employed to create more wealth. Wealth is “...the value of assets owned minus the value of liabilities owed at a point in time. Wealth can be categorized into three principal categories: personal property, including homes or automobiles; monetary savings, such as the accumulation of past income; and the capital wealth of income producing assets, including real estate, stocks, bonds, and businesses.5”
This definition forms the foundation of modern wealth management currently practiced in the commerce and industry. This definition comprises personal, organizational and national wealth and considers net wealth after liabilities as a proper measure of net worth. Wealth is therefore net assets with potential to generate income for the holders. Income, which is merely
and the Sunnah. It should also be known that not every kind of wealth can be privately owned. The three public goods declared by the Prophet (PBUH) are water, herbage (grazing land, forest, mines) and fire belong to the community .
This article analyses the concept of wealth from conventional practice to the Shariah perspective. Necessarily, it provides some comparative deliberation on Islamic Wealth Management (IWM) and its modern conventional practices. The process of IWM is also discussed, compared to conventional practices.
CONCEPT OF WEALTH – MODERN VERSUS SHARIAH PERSPECTIVEFrom the Islamic perspective, all resources or wealth belong to their Creator (swt) who has provided these resources to mankind (Quran 45:13) with the expectation that they would be held in trust (Quran 33:72). Humanity is accountable for the manner in which wealth is created, amassed and distributed. This is a fundamental tenet of Islam and Islamic Wealth Management . The Islamic perspective of wealth is based on 1,400 years of consensus of scholars of Islamic jurisprudence (Ijma), established from the authentic sources of Shariah: the Quran and the Sunnah (the sayings and practice of the Prophet Muhammad (PBUH).
Wealth in Islam comprises both tangible and intangible assets, similar to modern meaning of wealth (Jusoh & Muhammad, 2005). The significant difference however, is that tangible (money, real estate, commodities, etc.) and intangible assets (intellectual capital, copyrights, patents, financial rights, etc.) have specific rules in Islamic jurisprudence that limit uncontrolled trade of these assets. For example, same currencies and commodities can only be exchanged at par and at spot, whilst differing currencies and commodities can be traded at agreed prices but at spot.
The concept of ‘spiritual’ wealth is also relevant here. Most world religions including Islam move beyond the nominal perception of wealth and believe that the ethical management of wealth leads to contentment of the heart and success in the afterlife. In Islam, the spiritual precept is considered in the context of ‘zuhd’ or ensuring that love of wealth has not entered the heart (simply: greed). Here, specific prohibitions must be avoided to establish ‘zuhd’ or maintain spirituality of wealth in Islam: Al Bukhl or miserliness; Al Israf or wasteful expenditure
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the periodic addition to wealth is the result of the efficiency or marginal contribution of capital and the synergic combination of labor-entrepreneur. If the production techniques – via Adam Smith’s specialisation principle – is applied to production activities, the synergic combination of capital
After a few centuries of Calvinist influence, wealth maximisation has become entrenched within the capitalist system, deviating significantly from the long-standing idea that wealth is not an end in itself but a means to fulfill the needs of wealth holders and the community at large.
and labor adds further efficiency to production and further factor productivity.
This mainstream concept of wealth is based on the widely-held (and currently being revived) Christian concept of wealth. Contemporary Christian interpretation is slowly moving away from the centuries-old Calvinist5 idea that wealth is a sign of God’s gift to the wealth holder.
This was later interpreted in the ensuing centuries as the idea of personal wealth maximisation. The concept now forms the foundation of modern wealth management practices with a very thin-line between moral and ethical restrictions on how wealth is created, managed and distributed (except as dictated by the secular laws relating to acts of fraud, criminal breach, trust as stipulated in these laws). After a few centuries of Calvinist influence, wealth maximization has become entrenched within the capitalist system, deviating significantly from the long-standing idea that wealth is not an end in itself but a means to fulfill the needs of wealth holders and the community at large.
ISLAMIC WEALTH MANAGEMENT (IWM) RESTRICTIONSThe total assets of IWM is no more than a fraction (approximately 2%) of the world’s conventional assets. But the steady growth of this unique IWM system has made it on the global stage, practiced in more than 76 countries and adopted by secular governments in sovereign fund-raising7.
Unlike mainstream wealth management practices, IWM is bound by restrictions to ensure it serves its objectives. The first restriction is that no wealth increase is permissible if the wealth is created through Islamically illegitimate production and/or investment activities. That is, it is only lawful to earn returns on permissible and risk-sharing based investments. From a Shariah perspective, impermissible earnings refer primarily to interest income and proceeds from other impermissible sources of income such as the sale of pork or alcoholic beverages (Elgari,2000). Although Shariah scholars provide a tolerance level for incidental gains from impermissible activities
(less than 5%), the purification of tainted or impure income must be conducted. This involves removal of the tainted income and its distribution to charity. Islamic
financial institutions practice
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different approaches towards cleansing. While some banks create their own charity account for each Islamic fund, such as Al-Meezan bank and HSBC Amanah, others donate the calculated non-permitted incomes to different charitable institutions as decided from time to time at the discretion of the Shariah boards.
This restriction on permissible income has been widely accepted in more than 76 countries that have started some form of Islamic banking practices since the 1960s. The earning returns from permissible production and investment are expected to improve the well-being of communities and financial stability compared to the one-sided no-risk-shared investments under the current modern wealth management practices.
The second restriction is on expenditure: the owner may not spend his wealth frivolously (Quran 17: 26-27) as he will be questioned on its use8 . He is however encouraged to spend on himself, his family and those in need. Beyond routine consumption and spending on others, he also has an obligation of alms-giving or zakat to alleviate the suffering of his fellow beings, starting with the next of kin, then the orphans, those dispossessed of wealth, the poor and the wayfarer, in that order (Quran 9:60). Zakat is paid at 2.5775% (solar year) of the annually assessed wealth. Therefore, wealth that has not been invested or left idle, will diminish over time, encouraging the owner to enter it into productive options.
Unlike mainstream wealth management prac-tices, IWM is bound by restrictions to ensure it serves its objectives.
The Islamic objective is economic justice through equitable distribution of wealth. This by no means restricts private ownership and entrepreneurship. In fact, the objective is for a wider circulation of wealth as the Qur’an explicitly prohibits the concentration of wealth among the rich few (Quran 59: 7). Rather, it encourages socially beneficial economic activity (Quran, 62:10 and 73:20). The insights of these verses also imply that the poor have a rightful share in the wealth of the rich, which mandates annual reduction of the wealth by mandatory charity (Zakat of 2.5%), further necessitating the productivity of wealth.
This qualifier is important: the Calvinist idea under a secular concept of wealth enables wealth maximisation but with no requirement to spend other than on one’s needs and wants. For example, with the advent of modern capitalist ideas in the 1990s, individuals have justified accumulation of huge wealth in households so much so that the inequality of wealth has dramatically increased to a level of the top 1 per cent of the households owning 49% of all the wealth compared to 1950 when top 10% of households owned half the global wealth. The wider concentration of wealth in the current period has largely resulted from the revisionist thinking that capital is an important component for development, so capital is increasingly becoming untaxed in the hands of wealth holders.9
Islamic wealth management requires periodic distribution of accumulated wealth to the needy in the society, diminishing the inequality gap. This is what is meant by wealth which should be used to further good deeds here and in hereafter.
Besides the mandatory alms (zakat), Islam encourages its followers with wealth entrusted to them to establish voluntary endowment in the form of a charitable trust (waqf) (Hoexter, Eisenstadt, & Levtzion, 2002). This is meant to provide for beneficiaries (family and communities) during and after the wealth-holder dies (Maududi, 1960). Historical sources suggest that the government public service in
modern times was largely provided by the venerable institutions of these awqaf, which catered to the basic needs of the community in Islamic countries before 1900 AD.
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SOCIAL JUSTICE UNDER IWMIWM is based on the practice that, whilst there is no objection to wealth creation in permissible ways, wealth should not be used to exploit those without wealth via one-sided contracts.
Conventionally, wealth has been generated by undertaking no-risk-sharing ventures to which wealth of an individual or an entity is made available to produce goods useful to society. Modern banking accepts deposits, ‘increases’ its value using the money multiplier and lends this inflated ‘virtual money’ to entrepreneurs in need of funds. They engage in one-sided contracts requiring an interest (or Riba in Arabic which means an increase over the amount lent) irrespective of whether the entrepreneur achieves profit or loss from the funds. This bank-lending generates passive interest income to capital owners, increasing the concentration of wealth among a few.
This aspect of interest-based lending without considering the borrower’s situation is social injustice. Entrepreneurs with ideas may have to forego their earnings or even lose the enterprise if the venture loses money. Foreclosure laws enable banks to liquidate the venture without considering loss of skill to the society or the loss of wealth of the entrepreneur, protecting the lender and its ‘virtual’ money. Thus, financing through risk-sharing methods enables a balanced contract that is more equitable and more profitable for both the funder and financing client. Risk-sharing methodology involves the use of venture capital techniques and partnerships that fund
an enterprise on the same basis as secular laws relating to shareholder claims to profits (unless the firm is in voluntary closure, when capital will be returned to fund owners).
To serve social justice, wealth is not considered legitimately earned unless the risk-and-rewards are both shared in a financial contract: so one-sided no-risk-sharing contracts are not permitted under IWM. IWM allows a socially permissible use of wealth to fund a permitted economic activity based on a balanced contract that provides (i) the fund provider with income (or profit) (increase to the amount funded) only in the years when a profit is made and shared on a pre-agreed basis proportional to the risk of the venture; (ii) it provides for deferment of dividends if no profit is made due to no fault of the entrepreneur; and (iii) the loss of a failed venture may mean loss of wealth of the funder and loss of efforts on part of the entrepreneur. This is an important ethical foundation of IWM. Unfortunately, this introduces a free-rider problem that could be mitigated through effective supervision and joint participation in decisions relating to the funded venture.
THE BASIC STRUCTURE OF ISLAMIC WEALTH MANAGEMENTWealth Management is a process of inter-linked activities to achieve a set of financial objectives. On a similar note, IWM is no exception: it involves wealth generation, accumulation, preservation, purification and distribution. All these processes are interdependent and unlike conventional wealth management, these are carefully guided by the requirements of the Shariah. Wealth, once created, is invested to increase the wealth through pro-society productive investments via financial institutions such as banks, insurance companies, mutual funds, hedge funds, and stock/bond markets. This process shares many aspects in common with conventional investment management. The differences for IWM come from restrictions – or compulsory ethical filters - applied to all aspects of the wealth management process. Such restrictions or filters begin from the creation of wealth to the accumulation stage and extends to the distribution of wealth. Distribution of wealth as well, should benefit (i) next of kin in need; (ii) the indigent; and (iii) the wayfarers, before considering contributions as endowments (waqf) that ensure future streams of income for society.
Creation of wealth is defined more broadly than in conventional practice. A set of filters
Islamic wealth management requires periodic distribution of accumulated wealth to the needy in the society, diminishing the inequality gap. This is what is meant by wealth which should be used to further good deeds here and in hereafter.
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are applied to financial transactions that ensure permissibility and productive activities to promote society’s wellbeing. Such binding ethical restrictions (filters), which could only be exempted under juristic necessity10 , are absent in modern wealth management practices based on secular laws, despite the fact that secular laws also have societal objectives.11
The principle of permissible wealth creation places society’s welfare on par with personal welfare. This somewhat limits the unfettered pursuit of personal wealth creation and also the pursuit in the management of wealth practices that are inimical in the long term to the sustainability of a society and the planet (commonly referred to as socially responsible investments or SRIs). This is akin to the ‘people and planet first before profits’ movement adopted by investment funds in the last 20 years that has garnered more US$23 trillion in investment funds as of 2016 (Global Sustainable Investment Review, 2016).
The harmful aspects of the wealth process are eliminated or diminished through binding constraints, accepted by those subscribing to the Islamic belief system. Thus, the idea of permissible creation of wealth (this brings in ethical considerations beyond man-made laws as binding) and permissible investments and permissible use of wealth is practiced to benefit the community at large. These constraints are widely publicized and are well known today. Wealth cannot be earned from activities that are not permitted (weapons of mass destruction; production of intoxicants for personal consumption; production of unhealthy food defined as pork; degrading environment; etc.). Wealth creation has to be from permissible activities that places the welfare of the community first as a requirement for wealth investments. The objective is to avoid anti-societal activities to capital sources. Once such wealth is created in this filtered manner, then the wealth is permitted to be cumulated through permissible yields of investments forming additions to wealth over time12. Wealth therefore, has two components:
The second part of wealth is from the requirement to invest it to generate more. Islam discourages idle wealth for the obvious reasons of economic stagnation, subjecting it to a 2.5% charitable contribution. In a broader sense, the increase in wealth must exceed 2.5% to contribute to net benefits or else, it would diminish completely in 40 years, without even considering time value discounting.
Next is the objective of wealth accumulation. The Islamic belief is that wealth is apportioned according to God’s own discretion, such that no person can envy wealth holders nor should the wealth holder treat the wealth as his own. Specific commands exist to consider that a portion of the wealth rightfully is due to the poor.
While wealth accumulation is encouraged, the purpose of the accumulation is first to fulfill one’s personal (the betrothed and the family) needs and wants, then the needs of the broader community. The holder is expected to enjoy his wealth, adorn good clothing, and acquire conveniences, etc., without being miserly (nor be a spendthrift) while at the same time treat the wealth as a trust to improve the lives of others (Quran 7: 31).
Where does a wealth holder invest wealth? There are a variety of permissible instruments: equity market instruments (musharaka) approved as shariah compliant; sukuk securities as debt market instruments; mudaraba (profit-shared) banking products offered to public and to businesses; money market instruments that are beginning to be offered in recent years; insurance, that is, takaful and re-takaful as mutual insurance; and real estate. Shariah compliance is achieved by applying guidelines (for example, Bank Negara Malaysia Shariah resolutions, AAOIFI Shariah Standards) on identification of prohibitive elements within financial transactions. Significant advances have been made in the development of sophisticated Islamic investment products within several global niche markets. For example, approximately 40% (80% in Malaysia) of all exchange-listed stocks in several countries – there are 24 such indices - are considered permissible investments as
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they apply forms of risk-sharing contracts (often referred to as balanced contracts). Therefore, an estimated US$70 trillion of stocks are potentially available for shariah-compliant investment. Add to this the new debt market called sukuk traded in 17 countries. The total traded and non-traded sukuk is estimated to be about US$1.2 trillion, introducing an additional investment vehicle for Islamic investors with low-risk return. The total investments in Islamic mutual funds is estimated to be about US$240 billion in about 700 Islamic mutual funds whereas the total premium in takaful insurance is estimated to be about US$65 billion. Mudaraba or investment accounts are available at Islamic banks globally for less savvy investors (There is no estimate of the total amount invested in this form).
Wealth protection and wealth cleansing should be considered together. If wealth is appropriately earned from permitted economic activities and then accumulated, there is no need for cleansing. Though the ideal of such high-flouting wealth
creation in the right way, it might not always be possible in a community where conventional practices are in place. For example, people living under a secular system may not have freedom to avoid interest earned on pension fund schemes, compulsory interest on deposits, etc. In that event, any impermissible gains are expected to be distributed to the needy as a method of purification or cleansing. In this manner, the wealth holder is made conscious of his/her duty to be careful about how he/she generates or preserves the wealth.
The process of cleansing applies in corporate finance and investment as well. The business environment and the contemporary state of economic affairs, even within countries with predominant Muslim population, are not free from questionable sources of income. These may arise from borrowing and lending by way of receiving and giving interest. In other words, it is not always possible for a corporation to survive without access to basic conventional banking services as well as money markets. Therefore, having wealth which is tainted or impure income constitutes a real dilemma. Here again, the cleansing applies. This is not a new subject for the Shariah. The relevant verse in chapter al-Baqarah clearly indicates that the income originated from usury or other impermissible activities must be purified.
“And if you repent, then you shall have your principal [without interest]. Wrong not, and you shall not be wronged.” (2: 279).
The Sunnah also addresses the issue on cleansing, and draws attention to the rejection of impermissible income: Abu Huraira narrated that the Prophet (PBUH) said: “Allah the Almighty is Good and accepts only that which is good.”
The latter part of IWM deals with the distribution of wealth. The mandatory charitable deduction (Zakat) is considered a means of spiritual cleansing of the wealth one has acquired in excess of a minimum threshold referred to as the nisab. The wealth-holder makes a purposeful but mandatory contribution of part of the wealth to take care of the indigent members of the society each year. The operators of the institutions collecting this money have guidelines developed over the centuries on the rightful use of such money: there are eight classes of recipients of this donated wealth as clearly indicated in the Quran (9:60).
Zakat is thus a form of wealth tax that should be included in the financial plan of those requiring
Unlike mainstream wealth management practices, IWM is bound by restrictions to
ensure it serves its objectives.
While wealth accumulation is encouraged, the purpose of the accumulation is first to fulfill one’s personal (the betrothed and the family) needs and wants, then the needs of the broader community.
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IWM. Zakat excludes voluntary charity that may be provided to those that fall out of the eight categories defined in the Quran. For example, the voluntary contributions made during the month of fasting is given to institutions set up for the purpose of alleviating suffering: the soup kitchens; the hospitals; the orphanages; educational institutions; etc. The second form of distribution is the voluntary act of a wealth holder to bequeath income-earning assets to institutions with public purpose to serve the welfare of the community to take care of the needy. This is an endowment, waqf or bequest a wealth holder makes if she/he wishes to dispose part or all of the assets to provide income for charitable purposes long after the demise wealth holder: this is doing good for the eternal soul even after death ends a life lived.
The inheritance law is part of the distribution process. The premise of this law is that wealth originally belongs to God and man is only entrusted to have it while he is alive. When he dies, the wealth goes back to its original owner i.e. God and it is up to God to wish how it is distributed through inheritance.
In brief, Islamic Wealth management is broadly similar to the modern wealth management practices except for the filters at each stage to ensure that the Shariah requirements are met. If there are issues of non-compliance, the Shariah provides guidance to address these issues.
CONCLUSION In the first section of this article, the capitalist idea of what wealth is, was introduced before discussing IWM and its provisos. Wealth is a stock of value, and wealth is essential to producing new wealth by combining capital and labor-entrepreneurship, which then results in total factor productivity with a return commensurate with the efficiency of capital and labor invested.The Islamic and Christian beliefs are based on the premise that all wealth belongs to God, and that the goal of wealth is to earn merit through good deeds. This is possible from God-pleasing application of wealth to improve the welfare of the society in order to earn a blissful life in the hereafter. World religions subscribe to some form of this belief system, except that the introduction of ethics to economic activities from the theological perspective changes the way the activity is conducted.
The restrictions (filters) on the creation of wealth as permissible activities was noted in the context
of constrained wealth maximisation objectives. Although Adam Smith’s ‘Wealth of Nations’ is often cited as the sources of modern economic ideas, it is equally important to refer to his Theory of Moral Philosophy, published earlier than 1776. These two works taken together would introduce some of the moral imperatives of wealth and its usage. Much later, Lord Keynes (1931) shared some criticism of modern ideas of economics, which is worth mentioning here:
“When accumulation of wealth is no longer of high social importance, there will be great changes in the code of morals…we have exalted some of the most distasteful of human qualities into the position of the highest virtues. The love of money as possession [is] somewhat disgusting morbidity… But beware! The time for all this is not yet. For at least hundred years we must pretend to ourselves and to everyone that fair is foul and foul is fair; for foul is useful and fair is not. Avarice and usury and precaution must be our gods for a little longer still. For only they can lead us out of tunnel of economic necessity into daylight.”
This excerpt questions some of the current practices in economics. For example, economists’ belief that more is better than less is not necessarily true, at least in the case of wealth in the hands of individuals. As stated in the Quran (102: 1) the more one has the more one desires, if there is no belief in wealth as a gift to improve the lives of the community at large.
Max Weber explained capitalism as a product of the Protestant ethics, so wealth is a reward to
The soup kitchens; the hospitals; the orphanages; educational institutions; etc. The second form of distribution is the voluntary act of a wealth holder to bequeath income-earning assets to institutions with public purpose to serve the welfare of the community to take care of the needy.
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the faithful engaging in rightful earnings, as John Calvin legitimized the pursuit of wealth made dangerous by the Roman Church for a millennium and more (Weber, 1930). He further concludes how Calvin’s influence helped to radically replace the medieval position of wealth as a means of sharing with the community – the idea of 10 per cent tithe. The resulting stand is the “… spirit of capitalism is the pursuit of wealth as an end in itself, to the point of being absolutely irrational”: (Weber, 1930; chapter 2). The Islamic belief system rejects this stand: wealth is permissible if it is meant to be spending for the sake of pleasing the Creator: it is fair to spend on one’s needs/wants - meaning that fulfilling needs and wants of the created beings are in the radar as pleasing to God. What is pleasing are actions to spend wealth for doing good deeds, including on oneself.
The modern position on how concentration of wealth is not in the best interest of societies is expounded by Amartya Sen (1999). He argues that development in economics is actually the development of human beings. Thus, he identifies the incidence of unprecedented opulence in this century along with extreme deprivations as a serious problem for humanity to resolve: Adam Smith actually predicted this, 222 years before Amartya Sen was canonized by the Nobel award. Obviously new political action ought to be pursued if this disparity goes on unchecked, which has the potential to lead to the breakdown of civil society as the ruling classes have designed during the 20th Century. Perhaps this is the hidden meaning of Keynes when he refers to the “gods” of man in his times or the hidden meaning of Adam Smith who predicts envy of the disposed (or have-nots) to forcefully
take the wealth away from the opulent.Obviously these ideas of great thinkers have some bearing on wealth as we understand it in the 21st Century. Unprecedented wealth has been created and accumulated in the 100 years since the industrial revolution entered its most fruitful stage in the 19th Century. That and the Information Technology (IT) revolution that started in the 1970s are creating wealth at a much faster rate than in any other time in human history. Yet, instead of wealth ameliorating human condition, one observes the difference between the wealthy and those deprived of wealth is widening especially since the anointment of special positions given to wealth under the current brand of capitalism.
Wealth creation, accumulation and distribution have tilted in favor of the wealth-endowed households while production is shifting around the world to take advantage of income disparities to dictate where wealth can be amassed with little man-made constraints in such cheap countries. In this context, it is perhaps noteworthy to redefine wealth as a means not for fulfilling the needs/wants of the wealthy alone but also to share part of it to alleviate the needs of those who require help (including the next of kin) and as a requirement of the believing persons to recognize that the poor also have a legitimate share in the wealth of the wealthy. That is especially true for the top 1-10 per cent of the households with the ability to double their wealth through permissible investments in one life time. Hence, IWM has a relevance to the world today more so given the disparity of wealth that is well documented and requires a paradigm shift in the way wealth is managed by modern societies.
1. Abu Hurairah that the Messenger of Allah said: “Three things cannot be denied to anyone: water, pasture and fire.” Sunan Ibn Majah, Vol.3, Book 16, Hadith 2473
2. To Him (God) belongs all that is in the heavens and all that is on the earth, and all that is between them, and all that is under the soil.”The Quran further says , “..and give them something out of the wealth that God has bestowed upon you”; Quran 24:33. It is also customary to insert “swt”after each mention of the word God. For brevity, this acronym is left out in further parts of the text, except at the start of the chapter.
3. “The two legs of the servant (men) will be immovable until he is asked with regards to four matters: during his lifetime, how was it utilized, during his younger days how was it spent, with regards to his property, where (how) did he acquire it and how was it spent and lastly, to what extent did he practiced his acquired knowledge”. According to the Hadith reported by Al-Tirmidhi (2416), each individual will be asked on the day of judgement.
4. Ubada bin al-Samit (may Allah be pleased with him) reported Allah’s Messenger (may peace be upon him) as saying: “Gold is to be paid for by gold, silver by silver, wheat by wheat, barley by barley, dates by dates, and salt by salt, like for like and equal for equal, payment being made hand to hand. If these classes differ, then sell as you wish as long as payment is made hand to hand.” (Muslim, Hadith No 1569)
5. http://en.wikipedia.org/wiki/Wealth Definition. Accessed 16-02-2015. Wealth has two components: wealth that is in place at the time of investment, and the addition to wealth once wealth is invested in productive ventures. Chapter 2
6. John Calvin is identified with three other names for reforming the Roman Church that led to the rise of a brand of Protestantism. Under their influence in the 17-th Century, personal wealth maximization gave rise to the pursuit of wealth as permissible as wealth if a gift of God. Mainstream economists have attributed Calvin’s influence for the growth of wealth and the Protestant pursuit of wealth across the Earth.
7. The UK and South African governments have both launched Sukuk (Islamic debt securities) for fund-raising.8. Asmah related that the Prophet (peace be upon him) said “Spend, and do not count, lest Allah counts against you. Do not withhold your
money, lest Allah withholds from you. Spend what you can.” (Bukhari & Muslim)9. Abu Huraira related that the Prophet (peace be upon him) said “The Lord’s commandment for every one of His slaves is, ‘Spend on others,
and I will spend on you’”. (Bukhari, Muslim)
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By: Adam Ng, Ginanjar Dewandaru, Abbas Mirakhor (INCEIF)
This article discusses one of the myths and the new realities of risk sharing. The myth is that risk sharing contracts are costly and demand more information than debt
based contracts. The reality is that risk sharing contracts are incentive-compatible contract because there is an incentive structure in place to elicit truth-telling, trust, cooperation, hard work, and efficiency in resource management; factors that could not be written into contracts and enforced. Hence, these contracts attenuate coordination problem and improve the efficiency
of outcomes. Without this incentive structure, there are considerable transaction, monitoring and enforcement costs involved in designing and implementing contracts. The new realities of platform’s network effects, big data and machine learning which can equip decision makers, contractual parties and investors with informed decision making tools and valuable insights that can identify new sources of value that have never been visible before. This not only reduces the higher risk associated with equity investment as perceived by market participants, but also creates shared value in micro, small and medium enterprises (MSMEs).
NETWORK EFFECTS
AND BIG DATA MACHINE LEARNING
THE NEW REALITIES OF RISK SHARING:IF HU
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NETWORK ORCHESTRATOR ARE RARE, DESPITE SUPERIOR PERFORMANCES&P 500 BUSINESS MODEL COMPOSITION, AS OF NOVEMBER 2013
NETWORKORCHESTRATORTECHNOLOGY
CREATOR
SERVICES PROVIDER
ASSET BUILDER
NETWORK ORCHESTRATOR LEAD THE PACK ON PRICE -TO-REVENUEAVERAGE MULTIPLIER (PRICE-TO-REVENUE RATIO) FOR THE S&P 500 COMPANIES IN 2013
TECH-NOLOGY CREATOR
NETWORKORCHES-TRATOR
SERVICES PROVIDER
ASSET BUILDER
2.0
2.6
4.8
8.2
In principle, risk sharing can create shared value in finance through 1) taking different states of nature into account; 2) humanising and democratising of finance; and 3) design of information-sharing systems for wider-access to information on low-cost basis. First, the essence of risk sharing derives from the imperative of taking different states of nature into account, not all of which are necessarily favourable and connected to positive returns. In Islamic finance, the return on capital is determined on ex-post basis, which implies that future payoffs on contingent claims are function of variables in the real economy. It is the intrinsic interdependencies between time, cash flows and risks that force future cash-flows to be defined by economic activities under a world of uncertainty. Second, whereas democratizing finance means the extension of the principles of risk management to benefit all segments of the society, humanizing finance involves the use of various branches of cognitive science to improve “human-factors financial engineering.” Thus, financial innovation should benefit people at all income levels, providing insurance against systematic risks and idiosyncratic risks associated with the vicissitudes of earning a living, as also argued by Shiller (2003). Third, the design of information-sharing systems for wider access to information on low-cost basis, ensuring affordability or free access to poorer households and micro and small enterprises. Financial inclusion is not confined to access to financial services; it should include also access to timely and accurate information, which is essential to promote participation into equity and platform markets on informed basis (Maghrebi & Mirakhor, 2015). In what follows, two new realities (i.e. platform businesses and big data machine learning) in which the above can be operationalised in a more democratised and shared financial ecosystem are discussed.
The network effects of platform There are four broad categories of companies: asset builders (e.g. Ford and Walmart), service providers (e.g. Deloitte, Linklaters), technology creators (e.g. Microsoft), and network orchestrators (platform businesses, cloud, analytics, social networks, Internet of Things, and mobile technologies). A research in Harvard Business Review suggests that network orchestrators are the most efficient value creators, having a market multiplier (relationship between a firm’s market valuation and its price-to-earnings ratio) of 8.2 as compared with 4.8 for technology creators, 2.6 for service providers, and 2.0 for asset builders (Libert et al., 2014). Central to the competitive advantage of platform businesses
is their positive network effects – the “ability of a large, well-managed platform community to produce significant value for each user of the platform” (Parker et al., 2016). Organizations like Uber, Dropbox, Airbnb, Facebook and Upwork are valuable because of the participation of communities rather than their cost structure (capital, machinery or human resources). Financial data alone is no longer sufficient to present the true value and real growth of a business as approximately 80% of corporate market value is generated by intangible and unreported “assets” (Deloitte, 2014; Kester, 1984). In essence, platform business is a risk sharing business that creates shared value among customers, employees, partners, suppliers, and
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investors. Platforms are becoming an important business and organisational model that “creates value through leveraging unique information, and by orchestrating value generation by network participants” (Deloitte, 2014). It is transforming a range of economic and social arenas, from finance and investment to education and energy. A platform, according to Parker et al. (2016) in a book called “Platform Revolution”, is “a business based on enabling value-creating interactions between external producers and consumers. The platform provides an open, participative infrastructure for these interactions and sets governance conditions for them. The platform’s overarching purpose: to consummate matches among users and facilitate the exchange of goods, services, or social currency, thereby enabling value creation for all participants.”
Empowered by digital technology and smart software tools that connect different types of producers and consumers, platform businesses disrupts the linear value chain (typically used by pipeline businesses) by enabling the co-creation, change, exchange, and consumption of value in a variety of places and time (a complex value matrix). Parker et al. (2016) argue that platforms can out-compete pipelines in four ways: 1) platforms scale more efficiently by eliminating inefficient gatekeeper (e.g. Amazon’s Kindle platform allows anyone to publish a book based on real-time readers’ feedback to determine the success or failure of the book. Editors are replaced by automatic and massive market signals); 2) platforms unlock new sources of value creation and supply (e.g. just-in-time inventory
and fixed costs in traditional businesses (Hertz, hotels) vs. not-even-mine inventory in platforms (RelayRides, Airbnb); 3) platforms use data-based tools to create community feedback loops (e.g. Wikipedia built an information source comparable to Britannica by leveraging on a growing community of contributors); and 4) platforms invert the firm through the shift from internal activities to external activities (e.g. back-office enterprise resource planning systems front-office consumer relationship management systems out-of-the-office experiments using social media and big data cloud computing). In finance, the shift is from shareholder value and discounted cash flows of assets owned
NETWORK ORCHESTRATOR OUTPERFORM
ON REVENUE...AVERAGE REVENUE COMPOUND ANNUAL GROWTH RATE (CAGR) 2010-2012
... AND PROFITS...AVERAGE RPROFIT MARGIN, 2013
NETWORKORCHES-TRATOR
17.5
12.6
6.3
9.4%
TECH-NOLOGY CREATOR
SERVICES PROVIDER
ASSET BUILDER
NETWORKORCHES-TRATOR
2423
9
15%
TECH-NOLOGY CREATOR
SERVICES PROVIDER
ASSET BUILDER
Adopted from Libert, B., Wind, Y. (Jerry), & Beck, M. (2014). What Airbnb, Uber, and Alibaba Have in Common. Har-vard Business Review.
Empowered by digital technology and smart software tools that connect different types of producers and consumers, platform businesses disrupts the linear value chain (typically used by pipeline businesses) by enabling the co-creation, change.
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by the firm (financial and physical capital) to stakeholder value and interactions outside the firm (social capital, natural capital, reputational capital). Ideas are now produced through crowdsourcing rather than in-house experts and R&D departments. Global banks also realise the potential of crowdsourcing in banking. For example, the “RBS Ideas Bank” is an online portal for retail banking customers to submit ideas for the banks to improve; Santander uses “Better Together” where employees are encouraged to share their ideas on how the bank can be more simple, personal and fair. See also Florman et al. (2016) and Fasnacht (2009).
Big data and machine learningWhile a human can produce more sophisticated judgement than an algorithm, humans do not have such computing power when faced with an average of 4,000 brokerage reports a day consisting of 36,000 pages in 53 languages. The new reality is that the world is generating around 2.5 quintillion (2.5 x 1018) bytes of data daily. IBM estimates that 90% of the data in the world today was created in the last two years. These data are derived from diverse sources such as psychometrics, telecommunications, weather, social media posts, digital pictures and videos, purchase transaction records and cell phone GPS signals, among others. Big data is defined as “high-volume, high-velocity and high-variety information assets that demand cost-effective, innovative forms of information processing for enhanced insight and decision making”. The ubiquity of big data in various business sectors and social life has led to the emergence of innovative data management technologies and analytics that enables firms to create real-time intelligence from high volumes of “perishable” data. For instance, facial recognition technologies allow brick-and-mortar retailers to obtain
intelligence about purchase traffic, demographic profiles of their customers, and their in-store movement patterns. Clickstream empowers small and medium-sized enterprises (SMEs) to mine massive amount of semi-structured data to enhance website designs and to facilitate customized cross-selling (Cukier, 2010; Gandomi & Haider, 2015).
Big data is of no value if exists in a vacuum. To unlock its value, firms require efficient processes to transform voluminous and diverse data into meaningful insight for accurate, evidence-based decision making. Evidently, the unmanageable volume and complexity of big data have enhanced the potential of new machine learning and deep learning capabilities. Systems enabled by machine learning can contribute to better customer service, logistics management, record keeping and analysis, or even the writing of news stories (McKinsey & Company, 2016). In the investment arena, large global investment corporations like BlackRock are emphasising on “a data-driven, scientifically based and technologically aware research culture” to generate sustainable alpha in portfolio management. One area of research that has proved valuable is Edmans (2011)’s measurement of the impact of employee satisfaction on long-run stock performance. Over a 25-year period, a value weighted portfolio of Fortune magazine’s “100 Best Companies to Work For in America” outperformed industry benchmark by 2.1%. As insightful as it could be, the research is a backward-looking study of a dataset that is only updated once per annum and is limited to US firms. Driven by big data analysis and crowdsourcing research, BlackRock used an automated “web-scraping” system to examine job sites where employees provide feedback on thousands of employers across the globe, as well as various sources of employee sentiments from
While a human can produce more sophisticated judgment than an algorithm,
humans do not have such computing power when faced with an average of
4,000 brokerage reports a day consisting of 36,000 pages in 53 languages.
IBM estimates that 90% of the data in the world today was created in the last two years.
Big data is defined as “high-volume, high-velocity and high-variety information assets that demand cost-effective, innovative forms of information processing for enhanced insight and decision making‘‘.
The new reality is that the world is
generating around 2.5 quintillion (2.5 x 1018)
bytes of data daily.
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social media and blogs. In doing so, employee sentiment can be measured on a much broader scale in a more timely and comprehensive fashion (BlackRock, 2016).
Banks in Europe are also adopting machine learning techniques to devise new scoring system for clients in retailing and SMEs. Micro-targeted models are built to forecast more accurately who will cancel service or default on their loans (Pyle & Jose, 2015). However, SMEs are still lagging behind in the usage of big data analytics (e.g. adoption rate was only 0.2% in the UK in 2012). Coleman et al. (2016) identified two main features that can bridge between SMEs and big data analytics: cloud architecture (e.g. Amazon Web Services, Microsoft Azure and Google Cloud DataLab) and open source Big Data Analytics (e.g. Hadoop). Through cloud computing, SMEs can have an on-demand network access to a shared pool of configurable computing resources. In a research on the factors influencing the cloud usage by SMEs in Singapore, Malaysia and India, Gupta et al. (2013) revealed that ease of use and convenience is the biggest favourable factor followed by security and privacy and then cost reduction. The fourth factor reliability is ignored as SMEs do not consider cloud as reliable. However, SMEs do not want to use cloud for sharing and collaboration and prefer their conventional methods for sharing and collaborating with their stakeholders. To reap the full benefits of big data, it is crucial for SMEs to look within and develop the necessary skills, create small interdisciplinary and experimenting data teams, develop information governance to in sure data quality, security and data ownership.
New data from sources such as telecommunications, utilities, wholesale suppliers, customer purchases, and previously ignored data can now be incorporated in what is known by McKinsey as the “New Credit-Risk Models for the Unbanked” (Baer et al., 2013). For example, data about payments received or sent via mobile phone are useful proxies for income as well as ability to repay. A farmer who regularly accesses information about the weather using a mobile phone might be expected to have higher crop yields. Customers who call large numbers of people with regular patterns may be more reliable than someone with few connections. In recent years, the use of psychometric screening tool has proven to be useful in improving access to finance and entrepreneurial growth in the developing world’s “missing middle”. The Entrepreneurial Finance Lab (EFL) Research Initiative by the Center for International Development at
Harvard University is a case in point, which has “pilot tested various psychometric instruments on over 2000 entrepreneurs across Africa and Latin America, and currently analysing this data to better understand the psychological and intellectual drivers of entrepreneurial ability and risk of default”. The test provides analysis of one’s ability and willingness to repay, through a series of questions in a questionnaire, in order to measure characteristics like confidence, autonomy, opportunism, numerical reasoning skills and honesty.
Another recent study published in Decision Support Systems found that data mining techniques are able to identify the most profitable loans. Applying a profit scoring (internal rate of return) as an alternative to credit scoring systems in peer-to-peer (P2P) lending, Serrano-Cinca and Gutiérrez-Nieto (2016) found that profit scoring system using multivariate regression outperforms the results obtained by using a traditional credit scoring system, based on logistic regression. Factors that determine loan profitability also differ from factors that determine the probability of default. While the finding is derived from loan based activities, the prospect of using non-credit
Psychometric screening tools measure future upside potential rather than traditional risk management tools used by banks for debt contracts, which only measure downside risk. This makes psychometric screening particularly well-suited for alternative quasi/micro-equity instruments. Such contracts have the added advantage that they provide positive incentives for the investor by having them directly share in investee success.
- EFL Research Initiative.
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scoring as well as non-traditional data to assess equity based investment is promising.
Concluding remarksThe big data revolution that we are experiencing is making it easier to weigh and share risks. Sophisticated data analytic tools such as machine learning, natural language processing, scientific data visualisation and distributed computing are enabling us to map all possible risks and unleash potential value for better decision making, thus lowering the level of uncertainty that strains human’s cognitive power. Risk sharing can be further enhanced by leveraging the network effects of platform businesses. Through open, participative infrastructure for the interactions between the capital provider, entrepreneur, producer and consumer, platform businesses disrupt the linear value chain to enable the co-creation, change, exchange, and consumption of value in a variety of places and time. The challenge remains in ensuring better governance, proper protection of retail investors and data privacy, the stability of the marketplace, as well as fair distribution that is inclusive of the small businesses and community at large.
References:Baer, T., Goland, T., & Schiff, R. (2013). New Credit-Risk Models for
the Unbanked. McKinsey.BlackRock. (2016). The evolution of active investing: Finding big
alpha in big data.Coleman, S., Göb, R., Manco, G., Pievatolo, A., Tort-Martorelle, X.,
& Reis, M. S. (2016). How Can SMEs Benefit from Big Data?
Challenges and a Path Forward. Quality and Reliability Engineering International.
Cukier, K. (2010). Data, data everywhere: A special report on managing information. The Economist.
Deloitte. (2014). The value shift: Why CFOs should lead the charge in the Digital Age.
Edmans, A. (2011). Does the stock market fully value intangibles? Employee satisfaction and equity prices. Journal of Financial Economics, 101(3), 621–640.
Fasnacht, D. (2009). Open Innovation in the Financial Services: Growing Through Openness, Flexibility and Customer Integration. Springer.
Florman, M., Klingler-Vidra, R., & Facada, M. J. (2016). A critical evaluation of social impact assessment methodologies and a call to measure economic and social impact holistically through the External Rate of Return platform.
Gandomi, A., & Haider, M. (2015). Beyond the hype: Big data concepts, methods, and analytics. International Journal of Information Management, 35, 137–144.
Gupta, P., Seetharaman, A., & Raj, J. R. (2013). The usage and adoption of cloud computing by small and mediumbusinesses. International Journal of Information Management, 33, 861–874.
Kester, W. C. (1984). Today’s Options for Tomorrow’s Growth. Harvard Business Review.
Libert, B., Wind, Y. (Jerry), & Beck, M. (2014). What Airbnb, Uber, and Alibaba Have in Common. Harvard Business Review.
Maghrebi, N., & Mirakhor, A. (2015). Risk Sharing and Shared Prosperity in Islamic Finance. Islamic Economic Studies, 23(2), 85–115.
McKinsey & Company. (2016). The age of analytics: Competing in a datadriven world.
Parker, G. G., Alstyne, M. W. Van, & Choudary, S. P. (2016). Platform revolution: How networked markets are transforming the economy and how to make them work for you. New York: W. W. Norton & Company.
Pyle, D., & Jose, C. S. (2015). An executive’s guide to machine learning. McKinsey.
Serrano-Cinca, C., & Gutiérrez-Nieto, B. (2016). The use of profit scoring as an alternative to credit scoring systems in peer-to-peer (P2P) lending. Decision Support Systems, 89, 113–122.
Shiller, R. J. (2003). The new financial order: Risk in the 21st century. Princeton: Princeton University Press.
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By: Kinan Salim (PhD, Candidate), Mansor H. Ibrahim (INCEIF), Baharom Abdul Hamid (INCEIF) *This paper was awarded as “The Best Paper” during 2nd Islamic Finance Banking & Business Ethics Global Conference 2017
Introduction
Islamic banking industry has unprecedentedly witnessed a rapid growth since its inception four decades back in the late 1970s. However, the prospect of this flourishing industry is fast becoming gloomy in recent years. The
growth of Islamic banking almost matches the conventional banking, and their products are hardly distinguishable. Although the market growth slows down in the aftermath of the global
THE IMPACT OF
COMPETITION ON
BANKS EFFICIENCYDO BUSINESS MODEL AND CORPORATE
GOVERNANCE MATTER: EVIDENCE FROM
DUAL BANKING SYSTEMS
financial crises in 2008, the Islamic banking market has witnessed increasing competition. Islamic banks become more competitive and they managed to increase their market share meanwhile, conventional banks have successfully responded to the challenge by launching Islamic windows and subsidiaries. The increasing competition is considered as one of the main challenges that face Islamic banks, specifically, their performance.
Academic literature has extensively investigated the impact of competition on performance, mainly within the Structure-Conduct-Performance paradigm. In this regard, two
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Indeed, the increasing competition and the recent slow growth in Islamic banking might indicate a negative impact of competition on efficiency in dual banking systems. There are raising concerns about the implications of changing banking structures and increasing competition in these niche markets. However, the impact of competition on banks efficiency is poorly documented for dual banking systems and no consensus prevails in the literature on the implications of concentration on bank efficiency.
This paper fills the gap by examining the mentioned relationship for conventional and Islamic banking, which calls for a comparative
analysis. Moreover, it contributes to the literature by examining whether the efficiency of banks with different business models and corporate governance would respond differently to changes in competition.
Specifically, this paper measures the level and evolution of banking competition under a dual banking system in Islamic countries. Then, it studies the impact of competition on efficiency in the banking industry in these markets. Furthermore, it compares the competition-efficiency relationship across the different types of banks to explore whether the different business models and corporate governance affect the mentioned relationship.
In order to achieve the set objectives, we use a sample of 64 Islamic banks and 199 conventional banks over the period 2001-2014 operating in 10 countries where Islamic banks has a significant share of the total banking system or countries where Islamic banks achieve significant high growth. The aggregate assets of the Islamic banks in our sample covers more than 90% of the aggregate assets of Islamic banks globally. We obtained the measure of efficiency and its determinants using the stochastic frontier analysis where the determinants of technical inefficiency are embedded within the stochastic frontier function in one step. In specific, we use Wang’s model to allow competition to parameterize both the level and the variance of inefficiency. This helps in investigating the non-linear and additive relationship between competition and efficiency. Further, we use graph analysis of the marginal effect to illustrate the non-linearity of the relationship and to thoroughly examine the relationship across the different types of banks.
The findings The analysis of market structure and competition shows an increasing number and market share of Islamic banks over the last fifteen years, which spurs the competition in dual banking systems. with regards to efficiency, the findings support competition-inefficiency hypothesis where the increasing competition in the banking market leads to decreases in the cost efficiency of the banks in the market. One explanation might be that few large banks in high concentrated market are able to utilise the economics of scale to achieve higher levels of efficiency compared to many small banks in low concentrated market. Another explanation might be that the higher ability of the customers to do banking shopping in the competitive market which results in a
The increasing competition and the recent slow growth in Islamic banking might indicate a negative impact of competition on efficiency in dual banking systems. There are raising concerns about the implications.
competing hypotheses have been advanced in explaining the implications of competition on bank efficiency: the “Competition-Efficiency Hypothesis” and the “Competition-Inefficiency Hypothesis”. The former assumes that banks’ managers in concentrated markets enjoy a quiet life. Thus, competitive pressures would push them to enhance the performance by minimizing discretionary expenses and increasing their level of cost efficiency. Meanwhile, the later argues that banks in a less competitive market could be more efficient. Because large banks in a concentrated market have the advantage of scale economies; hence, they can improve their cost efficiency. Thus, the theoretical literature provides conflicting arguments regarding the relationship between competition and efficiency while the empirical literature is mixed, and the argument still unsettled. Moreover, a recent evidence shows that competition-efficiency relationship is affected by the business model and corporate governance of the banks. Thus, the relationship may vary across different types of banks.
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shorter life span of bank-borrower relationship. A shorter bank-borrower relationship decreases the bank’s efficiency.
While the basic findings support competition-inefficiency hypothesis, further investigation of the non-linear impact shows an evidence of quiet life hypothesis. Quiet life hypothesis emphasizes that the managers of the banks in less competitive markets may take advantage
of the market power of their banks in term of personal benefit by relaxing their effort, which leads to cost-inefficiency. Our findings show that the quiet life hypothesis seems to hamper the negative effect of competition on efficiency when banks operate in concentrated market. Additionally, the negative effect of competition on cost efficiency is almost counterbalanced in highly concentrated markets.
We further examine whether the marginal effects of competition on efficiency differ across banks types.
Interestingly, the findings show that the impact of concentration on efficiency is higher for Islamic banks compared to conventional banks. We suggest few explanations for these results. Firstly, in dual banking systems, Islamic banks faced higher competition than conventional banks, especially in markets where conventional banks are allowed to open Islamic windows. Secondly, based on the theoretical religious incentives of Islamic banks, we propose that quiet life hypothesis is less probable to exist in Islamic banks compared to conventional banks. The Islamic ethics of trading encourage charging fair prices, thus, Islamic banks may not charge the
MARGINAL EFFECT OF CONCENTRATION ON EFFCIENCYEF
FECT
OF
HH
I ON
EFF
CIEN
CY
ECONOMY OF SCALE & CONSUMER RELATION
QLH: MGT SLACK
HIGH
HHI
MIDLOW
0
0
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8
.1 .2 .3 .4
This figure illustrates the marginal effect of concentration on inefficiency in dual banking systems.
Quiet life hypothesis emphasizes that the managers of the banks in less competitive markets may take advantage of the market power of their banks in term of personal benefit by relaxing their effort, which leads to cost-inefficiency.
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maximal price accorded by their market power. The managers in Islamic banks may adhere to Islamic work ethics, and hence they would work efficiently and might not relax their efforts. Thirdly, the quiet life hypothesis is less probable to exist in Islamic banks due to their distinct business model and corporate governance. Islamic banks accept the customer deposits mainly through profit & loss sharing investment accounts. Investment account holders are more willing to discipline the management of the bank than conventional depositors do. The corporate governance framework of Islamic banks includes Sharia governance framework, which add another layer that exercise more disciplining on the management. The extra disciplining mechanism in Islamic banks provides them a level of immunity to quiet life hypothesis.
Furthermore, the analysis of the impact of competition on the variance of efficiency shows that banks in the higher concentrated markets have more varied efficiencies. In addition, we find that the market of Islamic banks is more homogenous in term of cost efficiency than the market of conventional banks.
To add credence to the findings of this research, a variety of robustness checks are performed. The robustness checks involve extensions of the baseline model specifications, and modification of the sample by including only countries with higher presence of Islamic banks. The results show consistency across the different estimations.
Policy implicationsThe findings of this paper suggest an important policy implications, especially regarding the regulation of the market structure in dual banking systems. In general, competition produces welfare gains. However, this paper finds that competition leads to cost-inefficiency of banks in dual banking system. Thus, the regulators in dual banking systems face a trade-off when they want to apply pro-competitive policies. A more competitive market promotes greater consumer welfare, yet it harms the efficiency of the banks. While, less competitive market induces banks efficiency but negatively affects consumer welfare.
However, in a highly concentrated market, the impact of competition on efficiency is almost
MARGINAL EFFECT OF CONCENTRATION ON EFFCIENCY_BY TYPE
0
0
2
4
6
.1 .2 .3 .4HHI Index
Islamic Banks Conventional Banks
Model_33
This figure illustrates the marginal effect of concentration on efficiency in dual banking systems. It shows the positive values of marginal effect of concentration on efficiency. We can see the higher magnitude for Islamic banks (the blue line) compared with conventional banks (the red line).
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counterbalanced, suggesting that there is no efficiency gains in increasing the concentration in the markets which are already highly concentrated. Hence, pro-competitive policies will generate social welfare without harming banks efficiency.
Moreover, we explain that the dominance of competition-inefficiency hypothesis might be a result of efficiency gains achieved by big banks through economics of scale. This raises the concerns about the size of Islamic banks. In general, Islamic banks are smaller in size compared to conventional banks. Additionally, in most of the dual banking markets, the regulator allows conventional banks to launch Islamic windows or subsidiaries, which allows them to achieve efficiency gains through economies of scales. Therefore, regulators need to pay more attention to the efficiency of full fledged Islamic banks. They may encourage the establishment of big full-fledged Islamic banks through mergers.
Moreover, this research suggests important implications for the banking industry since understanding the market structure of the industry is very essential for planning for business strategy. As emphasized by Proter’s “Competitive Strategy”, competitive intensity is one of the major forces in the industry which explain the performance of firms in the industry. For Islamic
banks in dual banking systems, the increasing competition in the Islamic banking market is a main challenge. It affects banks efficiency negatively through the economies of scale or through shorter bank-customer relationship. Conventional banks have responded to the increasing competition, they have amended their business strategy and made inroads into Islamic finance business by establishing their Islamic windows and subsidiaries. Hence, the conventional bank with its Islamic subsidiary maintain the bank-customer relationship and maintain the size. In contrast, full fledged Islamic banks are smaller than the conventional banks (and in some cases, smaller than their subsidiaries) where competition is tilted in favour of the latter. Thus, in order to compete head-on with conventional banks, full-fledged Islamic banks may look for strategic mergers to benefit from economic of scale and level the playing field with the conventional banks.
As an alternative, Islamic banks may adopt a product differentiation strategy by creating and emphasizing the ethical values in their products which are in line with the ultimate Shariah objectives.
This figure illustrates the marginal effect of concentration on efficiency in dual banking systems. It shows the positive values of marginal effect of concentration on efficiency. We can see the higher magnitude for Islamic banks (the blue line) compared with conventional banks (the red line).
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ON THE DYNAMIC LINKS BETWEEN COMMODITIES AND ISLAMIC EQUITY
By: Ruslan Nagayev, Mustafa Disli, Koen Inghelbrecht, Adam Ng*The original article was published in Energy Economics (2016), Vol 58, pp.125-140.*Accessible on: https://doi.org/10.1016/j.eneco.2016.06.011
Introduction
Have commodities and equity become a “financialized market of one”? Is such oneness persistent? Do diversification benefits still exist? Evidence behind these enquiries
offers important insights for policymakers, governments, traders and investors, and constitutes the main motivation for this paper. To assess the viability of commodities as an alternative asset class for Islamic equity investors, we present evidence on the extent to which returns in commodities and Islamic equity markets move in sync in both time and frequency domains. Our findings reveal that, throughout the January 1999-April 2015 period, correlations between commodities and Islamic equity were highly volatile and time sensitive. While there had been minimal correlation between commodities and Islamic equity prior to 2008, the relationship has strengthened since 2008, possibly attributed to the anomaly arising from the global financial crisis. Trends in the recent two years, however, suggest that the links between commodities and Islamic equity are heading towards their
This figure illustrates the marginal effect of concentration on efficiency in dual banking systems. It shows the positive values of marginal effect of concentration on efficiency. We can see the higher magnitude for Islamic banks (the blue line) compared with conventional banks (the red line).
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pre-crisis equilibrium, offering again potential diversification opportunities for investors. Divergence in correlations reveals that the behaviour of commodities is heterogeneous with varying potentials for diversification. Overall, gold, natural gas, soft commodities, grains and livestock are better portfolio diversifiers than oil and other metals. Relative to medium-to-long term investors, short-term investors gained better diversification benefits in most commodities during bullish, bearish and market recovery periods.
Tightened correlations and heightened asset volatilities suggest that commodities and equity tend to move towards a “market of one” during global economic downturns. For Islamic equity investors, this implies that diversification benefits may not be as strong when it is needed the most. In most cases, such “oneness” is persistent in the medium-to-long-term horizon. However, evidence of financialization of commodity markets in the short run remains equivocal as inferred from our analysis. Against this backdrop, our findings contribute to two strands of research: the possible existence of financialization for policy and commercial considerations in different market conditions; and the potential benefits of investment diversification across time scales.
From a traditional perspective, commodity and equity markets are inversely related and, therefore, commodities are considered to be good portfolio diversifiers (Kang, 2012). However, the increased financialization of commodity markets and the
impact of financial factors
on commodity price volatility have contested this interpretation. With exchange-traded derivatives on commodity markets being 20 to 30 times larger than physical production and with massive speculations on temporary price movements, the real markets are now transformed into financial markets driven by market sentiments rather than fundamentals (Domanski and Heath, 2007; Silvennoinen and Thorp, 2013). Therefore, the ensuing short-term commodity price movements cannot be fully explained by the supply and demand of commodity users (United Nations, 2012). Contemporary trends in commodity markets have cast scepticism on the diversification benefits of commodity investments. An increasing correlation across equity and commodity returns would discourage investors from choosing commodities as a refuge during periods of stress in traditional asset markets. If more investors are including commodities in their portfolios, negative news in one market, as result of a growing set of common state variables driving stochastic discount factors, may cause liquidation across several markets (Kyle and Xiong, 2001). This will generate more variation in correlation and volatility, and minimize diversification benefits for both equity and commodity portfolio managers (Kyle and Xiong, 2001; Silvennoinen and Thorp, 2013). On the other hand, studies have postulated that “real economy” factors such as the increasing demand from large developing countries and regular supply shocks are key to explaining commodity price volatility, and that the underlying factors that influence commodity prices are distinct from those that affect the value of stocks and bonds (Daskalaki and Skiadopoulos, 2011;
Geman and Kharoubi, 2008). Understanding the dynamic link between commodities and
equities is therefore important.
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To date, studies on the link between commodities and equities have mainly focused on mainstream conventional equity indices such as the US S&P 500 and Dow Jones global equity indices. With the launch of Islamic equity indices, Islamic funds and global sukuk in several markets since the 1990s, Islamic finance industry has been fast emerging as a viable market offering alternative asset classes. Although the industry is still a small share of global financial market with a total asset size of US$ 2 trillion in 2014, it is set to grow 15-20% annually in many of its core markets and is expected to expand the international reach of issuers and investors. Growing demands from a significant, and relatively unbanked, Muslim population (23.4% of global population in 2010) as well as faith-based and socially responsible investors have been key growth drivers of the Islamic finance industry. Within the Islamic asset allocation universe, equity funds represent one-third of Islamic funds worldwide. Islamic equity indices have proven to be valuable to Islamic fund managers, who have benefited from standardised screening methodologies and the growing number of Shariah-compliant securities, as well as to those investors searching for portfolio diversification and ethical investment opportunities (IFSB, 2014). The screening excludes businesses engaged in immoral activities (e.g., weapon, gambling, etc.) and firms that exceed a given limit of leverage and interest-bearing investments. As a result, large non-compliant firms are typically excluded from the pool of investable assets. This restricts the Shariah compliant investable universe such that the portfolio exhibits more volatile returns due to under-diversification, composition of smaller firms, and sector concentration (Hussein and Omran, 2005). Yet, some studies have shown that levered firms tend to exhibit an inverse
relationship between current returns and stock volatility (Black, 1976; Christie, 1982). In particular, the low leverage and asset-backed nature of Islamic equities imply that real and financial sectors are closely linked, and that exposure to volatility spillovers is limited (Majdoub and Mansour, 2014).
Limited investment opportunities in the Islamic market render the commodities market a natural complement to Islamic investment. Tangible and spot commodities meet the requirements of non-interest-bearing transactions and ethical screening. Our study contributes to the literature by focusing on the time-varying relationship between commodities and Shariah-compliant equities. We examine whether Islamic investors could retain the opportunity to reap diversification benefits by incorporating various types of commodities into their equity portfolios across short, medium and long-term horizons under different market conditions. To the best of our knowledge, this study is the first to investigate such a relationship in both time and frequency domains. We consider 17 commodities from five categories, namely energy (crude oil and natural gas), precious metals (gold and silver), industrial metals (aluminum, copper, zinc, lead and nickel), grains and livestock (corn, soybeans, wheat and cattle), soft agriculture (cocoa, coffee, sugar and cotton). Such a variety of commodities allows us to examine whether commodities can be considered as a homogeneous asset class vis-à-vis Islamic equity.
A battery of econometric models is combined to capture the dynamic and multi-time scale nature of our research. First, the multivariate generalized autoregressive conditional heteroskedasticity dynamic conditional correlation (MGARCH-DCC) model is used to assess the evolution of volatilities and correlations between commodities and Islamic equity over time as well as their potential suitability as hedges for each other. This model has been widely used in related studies (Büyükşahin et al., 2010; Choi and Hammoudeh, 2010; Creti et al., 2013; Vacha and Barunik, 2012). Second, we apply the wavelet coherence analysis that allows for the study of time series in the time-frequency domain to uncover the dynamics of correlations between commodities and equity. The application of wavelets uncovers complex price-correlation patterns without resorting to ad-hoc specified time or frequency frameworks. This model has, amongst others, been used by Madaleno and Pinho (2014) (oil and stock interactions), Vacha and Barunik (2012) (co-movement of energy
Islamic equity indices have proven to be valuable to Islamic fund managers, who have benefited from standardised screening methodologies and the growing number of Shariah-compliant securities.
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commodities), and Dewandaru et al. (2014) (Islamic and conventional equity markets). Specifically, we first use MGARCH-DCC because variations in correlations and volatilities at higher frequency levels are richer and, subsequently, to have a more complete picture, we employ wavelet coherence to assess the co-movement between the assets on medium and high scales. Since commodity and equity markets are complex systems of interacting agents with varying term objectives and heterogeneous risk tolerance, these models collectively provide a more in-depth and robust analysis that seeks to reinforce the understanding of the subject matter.
Conclusion and research implicationsIslamic equity index investors are relatively under-diversified since they are subject to religious constraints. From this perspective, it is important to verify whether alternative markets could reduce their market exposure to risk and provide diversification opportunities. The commodity
market is a natural choice since spot trading is permissible according to the principles of Shariah. Applying MGARCH-DCC and Wavelet Coherence analyses, we examine the extent to which the commodities market co-moves with Islamic equity market. Our findings reveal that, throughout the January 1999-April 2015 period, the return correlations are time-varying, i.e., vary over different phases, suggesting that not all commodities make equally good diversifiers at all times. Gold, natural gas, agriculture, grains and livestock offer good diversification opportunity for short-term investors (below 32 days horizon) relative to oil and other metals before the 2008 financial crisis. Natural gas is the best diversifier in the short run during and after the crisis. Compared to short-term investors, medium-to-long term investors (32-256 days horizon) generally do not gain substantially more diversification benefits (except for sugar during the crisis) across different market conditions. Except for cotton, sugar, cocoa and soybean, long-term investors (more than 256 days) share
Pure financial trading products can be monitored within the framework of financial stability (see, for example, recommendations from IOSCO on regulation
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similar benefits from investing in the types of commodities like short-term investors.
The time varying dimensions could be captured by investment managers in their rebalancing activity in both passive and active investment approaches, allowing risk and return to be managed appropriately in accordance with investors’ specific objectives. Our results offer insights into a blend of passive and active investment approaches in a multi-asset portfolio. Different market environments tend to suit active or passive approaches. The 2008 global financial crisis is a prime example that underscores the need to be scrupulous about the management of investment risks. Passive Islamic investment managers can include both Islamic equity index and selected commodities indices into passive Islamic exchange-traded funds when the asset classes are not highly correlated. For Islamic investors seeking to outperform index benchmarks and to optimise from forces of change in financial markets, active and value-
oriented investment strategies would stand to benefit from the dynamic assessment of the link between different commodities and Islamic equity index. While passive index investment may introduce significant concentration and benchmark risks, active investment management is capable of generating outperformance (alphas) and managing the risks inherent in the adoption of a benchmark (beta of a portfolio’s performance). This could plausibly explain why short-term investors, who are attuned to more active management, gained better diversification benefits than medium-to-long term investors during the 2008 crisis.
In our view, high correlation in some of the commodity-equity series in long-term may not necessarily imply the existence of financialized markets. It is, therefore, important to have a balanced approach in both regulations and in investment. For regulators, it is important to ensure that markets are robust to derive the full benefits of wider participation of investors. Pure financial trading products can be monitored within the framework of financial stability (see, for example, recommendations from IOSCO on regulation and supervision of commodity derivatives markets). Principles and lessons from Islamic finance can be drawn to enrich such framework.
While demand for commodity may be influenced by similar factors driving the demand for equity, the supply profile of commodities differs from equity. Commodities’ supply is relatively inflexible over the short horizon, suggesting that periods of correlation with equity are typically short-lived. Unlike other financial assets, commodities are tangible assets that will eventually be driven by the demand and supply of goods (Bain, 2014). In the spirit of Baele et al. (2010), future research assessing the supply and demand determinants would shed more light on commodity and Islamic equity return co-movements. Although correlations have now abated over the short-term horizon especially in recent years, the market is still in the state of flux. Tendency of a potential re-financialisation can again result in ineffective diversification. Such concern warrants the need to have well-functioning markets as proposed by the G20 Study Group on Commodities (2011) and United Nations (2012).
The full article is accessible on: https://doi.org/10.1016/j.eneco.2016.06.011
Unlike mainstream wealth management practices, IWM is bound by restrictions to
ensure it serves its objectives.
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®
WHAT IS IKR?IKR is a centralised repository
that maximises the discoverability, accessibility and availability of INCEIF
research and intellectual contributions by utilizing INCEIF Islamic Finance
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THE WORLD BANKISLAMIC RESEARCH AND TRAINING INSTITUTE (IRTI)
GUIDANCE FINANCIAL GROUP
In collaboration withINCEIF
SUSTAINABLE DEVELOPMENT GOALS AND THE ROLE OF ISLAMIC FINANCEDECEMBER 12 TO 13, 2017 • KUALA LUMPUR, MALAYSIA
3 R D A N N U A L S Y M P O S I U MO N I S L A M I C F I N A N C E
www.inceif.org | +603 7651 4000
Organised by In Collaboration with
World Bank, IRTI and The Guidance Financial Group are pleased to organise an annual symposium bringing together a wide range of stakeholders from the industry, academia, regulatory and supervisory areas to engage in stimulating research. The aim is to promote exchange of cutting-edge ideas and foster objective discussion on Islamic economics and finance amongst academicians, policy makers, private sector and development practitioners. The symposium will allow people to gain practical and professional understanding in the field of Islamic economics and finance. It will enhance awareness of major current issues impeding the advancement of the industry. The proposed symposium would provide a platform for the participants from multilateral development institutions, governmental institutions and bodies, private sector, and academia to discuss recent outlook of Islamic Finance and their potential role in supporting and achieving the U.N. Sustainable Development Goals (UN SGDs). The symposium, which is a two-day event, is held in di�erent countries each year. Given the global outreach of INCEIF coupled with Malaysia’s strategic importance as a global hub of Islamic finance, the 3rd Symposium 2017 will be held in Kuala Lumpur, Malaysia on 12-13 December 2017. The theme of the symposium is “Sustainable Development Goals (SDGs) and the Role of Islamic Finance”. The symposium aims to show the close linkage of the UN SDGs with Islamic finance. Sponsoring the symposium will showcase the role Islamic finance can play in promoting inclusive growth, reducing inequality and accelerating poverty reduction. The symposium is expected to highlight how Islamic finance resonates clearly with the UN SDGs Agenda.
THE WORLD BANKISLAMIC RESEARCH AND TRAINING INSTITUTE (IRTI)
GUIDANCE FINANCIAL GROUP
In collaboration withINCEIF
SUSTAINABLE DEVELOPMENT GOALS AND THE ROLE OF ISLAMIC FINANCEDECEMBER 12 TO 13, 2017 • KUALA LUMPUR, MALAYSIA
3 R D A N N U A L S Y M P O S I U MO N I S L A M I C F I N A N C E
www.inceif.org | +603 7651 4000
Organised by In Collaboration with
World Bank, IRTI and The Guidance Financial Group are pleased to organise an annual symposium bringing together a wide range of stakeholders from the industry, academia, regulatory and supervisory areas to engage in stimulating research. The aim is to promote exchange of cutting-edge ideas and foster objective discussion on Islamic economics and finance amongst academicians, policy makers, private sector and development practitioners. The symposium will allow people to gain practical and professional understanding in the field of Islamic economics and finance. It will enhance awareness of major current issues impeding the advancement of the industry. The proposed symposium would provide a platform for the participants from multilateral development institutions, governmental institutions and bodies, private sector, and academia to discuss recent outlook of Islamic Finance and their potential role in supporting and achieving the U.N. Sustainable Development Goals (UN SGDs). The symposium, which is a two-day event, is held in di�erent countries each year. Given the global outreach of INCEIF coupled with Malaysia’s strategic importance as a global hub of Islamic finance, the 3rd Symposium 2017 will be held in Kuala Lumpur, Malaysia on 12-13 December 2017. The theme of the symposium is “Sustainable Development Goals (SDGs) and the Role of Islamic Finance”. The symposium aims to show the close linkage of the UN SDGs with Islamic finance. Sponsoring the symposium will showcase the role Islamic finance can play in promoting inclusive growth, reducing inequality and accelerating poverty reduction. The symposium is expected to highlight how Islamic finance resonates clearly with the UN SDGs Agenda.
(COMPANY NO.718736-K)
ISLAMIC WEALTH MANAGEMENT AND ITS RELEVANCEIN MODERN TIMES
Ju
ne
20
17
ww
w.i
nc
eif
.org
INC
EIF
Shamsher Mohamad Ramadili Mohd
ISLAMIC WEALTH MANAGEMENT AND ITS RELEVANCEIN MODERN TIMES
17PG
Research HighlightsThe New Realities
of Risk Sharing Network Effects
and Big Data Machine Learning
Ginanjar Dewandaru, Adam Ng, Abbas Mirakhor
2PG
From the Research PipelineIncome Inequality
Reduction through alternative financial
institutions to RibaMagda Ismail
PP18986/07/2017(034546)ISSN 0127-9998ISSUE 05 JUNE 2017
In Person