The Islamic finance industry has gained new momentum over the past decade. A combined use of securitization and derivatives offers considerable scope for reducing the risk exposures of Islamic financial institutions (IFIs) and thus improving their overall creditworthiness, Moody's Investors Service said in a new Special Comment. However, the Islamic finance industry needs to develop its own innovation phase and not imitate conventional derivative instruments in order for IFIs to maintain their special status and Shariah-compliant approach, Moody's report noted. In its report entitled “Derivatives in Islamic Finance: Examining the Role of Innovation in the Industry”, Moody's said despite the recent gloomy economic environment globally, the Islamic finance industry's total assets scaled new heights in 2009, rising to $950 billion. Moody's estimates that the market's potential is worth at least $5 trillion and the industry is continuing to expand globally. Derivatives are sophisticated instruments that can, if employed with care, enhance efficiency in Islamic financial institutions through risk mitigation, thereby making them more competitive as well as appealing to customers “In this context, IFIs are continuing to deliver Shariah-compliant returns whilst, at the same time, focusing on efficiently mitigating the associated risks through a new risk management approach, including the use of derivatives,” said Anouar Hassoune, a Moody's vice president - senior credit officer and author of the report. “If employed with care, derivatives can enhance efficiency in IFIs through risk mitigation, thereby making them more competitive as well as appealing to customers. However, their application in Islamic finance is highly controversial for reasons of speculation and uncertainty, two practices forbidden under Shariah,” Hassoune said. The varying scholarly opinions in the world of Islamic jurisprudence on the legitimacy of derivatives has so far translated into a total ban on these instruments in some countries and actual implementation - albeit on a limited scale - in others. “IFIs aim to utilize derivative instruments to hedge against risk and to improve risk monitoring practices. However, they are keen to do so in a Shariah-compliant manner, rather than imitating conventional derivative instruments - in order to avoid losing their special status as Shariah-compliant banks, which makes them very attractive to a large population of Muslims. For this reason, a new innovation phase in the industry is critical,” Hassoune noted. Despite their pivotal function, the use of derivatives in emerging countries in general, and in the Islamic banking sector in particular, has been limited, in part due to the absence of legal provisions, insufficient technical frameworks, underdeveloped capital markets, and/or inadequate accounting, regulatory and disclosure standards. Islamic banking, popularly known as ‘green banking', is a relatively new concept and has grown dramatically since its inception four decades ago. Under Islamic jurisprudence, the investor's interests cannot be compromised and - in principle - the socio-ethical component of the business takes precedence over profits. The use of derivatives requires an understanding of the distinction between hedging and speculating, which, if not handled effectively, can cause harm to investors' interests. In Islamic banking, all transactions are riba-free and are backed by tangible asset classes that are characterized by ample liquidity and low leverage financial strategies, which has led to robust profitability at IFIs. However, most analysts predict that the current soaring returns accompanied by robust liquidity levels and the low cost of doing business are not a sustainable advantage in the long-term given the rising competition, the inflow of educated investors, fluctuating oil prices and unpredictable economic fluctuations. The use of derivatives is a highly restricted practice due to disparate Shariah opinions. Currently, Shariah boards are deeply divided on the application of derivatives because of elements of speculation and trading of monetary assets such as options, which are not permissible in Islamic finance. In addition, derivatives products are deemed to amplify uncertainty on the markets. These concepts are known as Gharar and Maysir. Thus, even when considering their hedging application, the cons appear higher than pros for many Shariah experts, threatening the collective interest (Maslaha). Ultimately, the strongest objection to derivative products consists in a different perception of risk management between conventional and Islamic finance. Managing risk in Islamic finance means integrating it into real activity and sharing it equitably between stakeholders while conventional finance aims to split it off from the underlying asset. However, there is no consensus of opinions on these views among Shariah jurists. “This ambiguity in the legal framework involving alternative instruments is further exacerbated by the fragmented nature of the markets and each country following its own interpretation of the Shariah law,” Moody's report said. Moody's believes that IFIs' risk monitoring capabilities are highly underdeveloped due to below-par qualitative characteristics such as corporate governance and risk management, which take the form of weak asset-liability, investment, and liquidity risk management. Despite high levels of balance sheet liquidity, its efficient management of the asset-liability dynamic has always been difficult for IFIs and is exacerbated by the scarcity of alternative instruments. In order to minimize the inherent risk factors in financial transactions, there is a greater need to invent a range of products and hedging instruments that could unleash much-needed innovation in structured products. Such instruments not only assist IFIs with hedging but also serve as powerful marketing tools. “This step towards modernization is necessary to sustain their current performance and to develop them into a reliable niche,” the report noted. However, as risk management and corporate governance in IFIs are already below par relative to the rest of industry, this should be addressed concurrently with the introduction of new products into the pipeline. In the context of derivatives and securitization, Islamic transactions aim to achieve the same financial objectives as those pursued by conventional banks but ‘differ in their legal classification'. Herein lies the concept of securitization (for funding purposes) bundled with derivatives (for hedging purposes) through structured arrangements of asset ownership and payoffs, whereby Shariah prohibition calls for two or more contingent claims by utilizing implicit derivatives. Islamic banking is naturally inclined toward asset securitization due to the religious requirement of having ownership in the reference pool of assets. The advantages ensuing from securitization structures allow IFIs to carry out much-needed reforms in enriching their stagnant asset bases, controlling asset-liability issues, lowering costs and separating self-sustaining assets through SPVs. Sukuk, provided they are asset-backed (as opposed to non-recourse asset-based transactions), are an example of one of the most accepted forms of securitized credit finance instruments used to diversify risk and free up capital, although there have been fatwas and comments issued recently on its structure with regard to form and substance.
