In this final part, Dr. Abbas Mirakhor explores how Islam views risk and looks into the way conventional markets tackle risk. He opines that the stock markets, institutional rules of behaviour based on Islamic paradigms and government action can spread risk more effectively and create more robust financial markets.
Achieving the ideal: uncertainty, risk and equity markets
Uncertainty about future outcomes is a fact of human existence. If severe enough, it can lead to anxiety, decision paralysis and inaction. Lack of certainty for an individual about the future is exacerbated by ignorance of how others behave in response to uncertainty. Yet, individuals have to make decisions and take actions that affect their own as well as other’ lives. Making decisions is one of the most fundamental capabilities of humans; it is inexorably bound up with uncertainty. Facing an unknown, and generally un- knowable future, individuals make decisions by forming expectations about payoffs to alternative courses of action. They can do so using subjective estimates of payoffs to actions based on personal experiences. Alternatively, the person can use known probability techniques to form an expectation of returns to action. Either way, the expected outcomes will form an expression in terms of probability of occurrence of consequences to an action. In
other words, uncertainty is converted into risk. Risk, therefore, is a consequence of choice under uncertainty and exists where more than one outcome is possible. It is uncertainty about the future that makes human lives full of risks.
Risk can arise because the decision maker has little or no information regarding which state of affairs will prevail in the future. The decision maker does not or can- not consider all possible states that may prevail in the future. In this case, even if the decision maker wants to consider all possible future states, there is so much missing information that it is impossible to form expectations about payoffs to various courses of action. This situation is referred to as “ambiguity”. If severe enough, this type of uncertainty too leads to reluctance or even paralysis in making decisions. Peo- ple adopt various strategies of “ambiguity aversion”. One strategy is to exercise patience and postpone making decisions until the passage of time makes additional “missing” information available. In a number of verses, the Quran states: “Allah is with those who are patient” and “Allah loves those who are patient”.
Dealing with uncertainty is a form of examination from the divine overseer. A number of Quranic verses makes reference to the fact that this temporary existence is a crucible of constant testing, trials and tribulations (see for example verses 2:155 and 2:76). Not even the believers are spared. In verse 29:2 the Quran asks: “Do humans think that they will be left alone when they say: we believe, and they therefore will not be tested?” The fact that this testing is a continuous process is reflected in 9:126: “Do they not see that they are tried every year once or twice? Even then they do to turn repentant to Allah, not do they remember”. (See also 2:155). To every test, trial and tribulation in their life-expe- rience, humans respond and in doing so they demonstrate their measure of being self-aware and Allah-conscious. If the response action is in compliance with the rules of behaviour prescribed by the Supreme Creator, then it is considered the “best action” (11:7). The trial becomes an occasion for self-development and strengthened awareness of Allah (swt). Even then, uncertainty remains. Muslims are recommended not to ever assume they are absolutely certain of the consequences of their actions. They are to live in a state of mind and heart suspended between fear (khawf) of the consequences of their actions and thoughts, and the hope (raja’) in the Mercy of the All-merciful Lord Creator. All actions are risky because the full spectrum of future consequences of action is not known. The Quran refers to this idea of uncertainty by suggesting that “ … at times you may dislike a thing when it is good for you and at times you like a thing and it is bad for you. Allah knows and you do not.” (2:216)
Risk sharing
While life and freedom are gifts of the Supreme Creator to humans, and un- certainty and risk are there to test and try humans to facilitate their growth and development, humans are not left unaided to face the uncertainty of life. Books, Prophets and Messengers have brought guidance on how best to make decisions and take actions to mitigate the risks of this life and to improve the chances of a felicitous everlasting life. Islam, in particular, has provided the ways and means by which uncertainties of life can be mitigated. First, it has provided rules of behaviour and a taxonomy of decisions – actions and their commensurate payoffs in the Quran. Complying with these rules re- duces uncertainty. Clearly, individuals exercise their freedom in choosing to comply or not with these rules. That rules of behaviour and compliance with them reduce uncertainty is an important insight of the new institutional economics. Rules reduce the burden on human cognitive capacity, particularly in the process of decision-making under uncertainty. Rules also promote cooperation and coordination. Second, Islam has provided ways and means by which capable individuals mitigate uncertainty by sharing the risks they face through engaging in economic activities with fellow human beings. Sharing allows risk to be spread and thus lowered for in- dividual participants. However, if a per- son is unable to use any of the market means of risk sharing because of poverty, Allah (swt) has ordered a solution here as well: the rich are commanded to share the risks of the life of the poor by redeeming their rights derived from the Islamic principles of property rights. Islam’s laws of inheritance provide a further mechanism of risk sharing.
Individuals in society face two types of risks. The first is the result of the exposure of the economy to uncertainty and risk due to external and internal eco- nomic circumstances of the society and its vulnerabilities to shocks. How well the economy will absorb shocks depends on its resilience which will in turn depend on the institutional and policy infrastructure of the society. How flexibly these will respond to shocks will determine how much these risks impact individual lives when they materialise. The second type of risk individuals face relates to personal circum- stances. These include risks of injuries, illness, accidents, bankruptcies or even change of tastes and preferences. This kind of risk is referred to as idiosyncratic and when they materialise, they play havoc with people’s livelihood. This is because often the level of their consumption that sustains them is directly dependent on their income. If their income becomes volatile so will their livelihood and consumption. Engaging in risk sharing can mitigate idiosyncratic risk and allow consumption smoothing by weakening the correlation between income and consumption such that should these risks materialise and the shock reduce income, consumption and livelihood of the individual do not suffer correspondingly.
Instruments of Islamic finance allow risk sharing and risk diversification through which individuals can mitigate their idiosyncratic risks. On the other hand, mandated levies, such as zakat, are means through which the idiosyncratic risks of the poor are shared by the rich as an act of redemption of the former’s property rights in the income and wealth of the latter.
It is important to note a nuanced difference between risk-taking and risk-sharing. The former is an antecedent of the latter. The decision to take risk to produce a product precedes the decision on what to do with the risk in financing the project. The decision to share the risk in financing does not increase the risks of the project but reduces the risks for individuals involved in financing it as it is spread over larger number of participants. It is also to be noted that the Islamic contract modes that have reached us are all bilateral real sector contracts. The accomplishment of the contemporary Islamic finance industry is to:
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- multilateralism the bilateral contracts as the latter move from the real sector to the finance sector; and
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- employ instruments of risk transfer available in the conventional finance but made them Shari’a-compatible.
Instruments of Islamic finance allow risk sharing and risk diversification through which individuals can mitigate their idiosyncratic risks. On the other hand, mandated levies, such as zakat, are means through which the idiosyncratic risks of the poor are shared by the rich as an act of redemption of the former’s property rights in the income and wealth of the latter. Other recommended levies, beyond those mandated, such as sadaqa and qard hasan, too play the same role. They help reduce the poor’s income–consumption correlation. In other words, the poor are not forced to rely on their low-level income to maintain a decent level of subsistence living for themselves and their families. It is possible that at some point in time even these levies can be instrumentalised to be included in Islamic finance’s menu of instruments for risk sharing. Instruments of risk sharing will help blunt the impact of economic shocks, disappointments and suffering on individuals by dispersing their effects among a large number of people. Having a suite of Islamic financial instruments available for all classes of people will assist in reducing their idiosyncratic risks and smooth their consumption. It will ensure that innovators, entrepreneurs, small and medium-sized firms have access to financial resources without the need to take all risks on themselves or, alternatively, abandon productive projects altogether. Takaful instruments will not only provide protection against health and accident risks but also insure against risks to livelihood and home values to protect people’s long-term income and livelihood. Only when such a full-spectrum of financial instruments is available, without transferring risks of any venture to a particular class or to the whole society, can Islamic fi- nance be said to have “democratised finance”. This would be in sharp contrast to the results of the “democratisation of finance” project which led to the recent global financial crisis in which the risks and failures of financial innovations were shifted away from financiers to society at large.
Stock markets
The primary instrument of risk sharing is a stock market. Developing an efficient stock market can effectively complement and supplement the existing and to-be-developed array of other Islamic finance instruments. It would provide the means for businesses and industry to raise long-term capital. A vibrant stock market would allow risk diversification necessary for the management of aggregate and idiosyncratic risks. Such an active market would reduce the dominance of banks and debt financing where risks become concentrated creating system fragility.
Idiosyncratic risks impact the liquidity of individuals and firms when they materialise. With an active stock market, individuals can buffer idiosyncratic liquidity shocks by selling equity shares they own on the stock market. Firms too can reduce their own idiosyncratic and liquidity risk through active participation in the stock market. They can reduce risk to the rate of return to their own operation – such as productivity risk – by holding a well-diversified portfolio of shares of stocks. Thus, incentives are created for investment in more long-term, productive projects. Importantly, by actively participating in the stock market, individuals and firms can mitigate the risk of unnecessary and premature liquidation of their assets due to liquidity and productivity shocks. Moreover, an active and vibrant stock market creates strong incentives for a higher degree of technological specialisation through which the overall productivity of the economy is increased. This happens because, without sufficiently strong risk sharing in the financial system through the stock market, firms avoid deeper specialisation fearing the risk from sectoral demand shocks. The reason stock markets are such an effective tool of risk sharing is that each share represents a contingent residual equity claim.
It can be argued that the actual operation of Islamic finance market differs from its ideal. In essence, there is a market failure: missing markets in equity sharing. Strong government policy action can create an incentive structure for the Islamic finance market to complete the spectrum of its instruments. The market has developed an array of short-term, liquid and reasonably safe instruments which are considered Shari’a compatible. This was not the case some thirty years ago. Then too, there was a missing market for Islamic instruments for which there was substantial demand. It took considerable commitment of resources and credibility on the part of governments, notably Malaysia, to organise this missing market to meet existing de- mand.
Malaysia’s success stems from not only the top-down push by the government but also other ingredients that had to be put in place for the venture’s success. The most important of these ingredients were human capital, regulatory structure and financial infrastructure to allow the emergence of Islamic banks. (One of the most important regulatory devises that created an effective impetus to the development of Islamic finance in Malaysia was the “no leakage rule”. This rule required that the financial resources mobilised by the Islamic banking window had to be utilised in empowering financially Islamic contracts only). The success of Malaysia in a relatively short span of three decades indicates it has adopted an appropriate framework for future progress. Specifically, its model would suggest that the same kind of intense dedication and commitment could successfully generate the ways and means of pushing the agenda of Islamic finance forward in terms of developing medium – to – long-term instruments of risk sharing. One strategy would be for governments to develop the long-term, high-return, riskier end of the spectrum of instruments of risk sharing, i.e. stock markets. This would create the needed incentive for the private sector to design and develop instruments in-be- tween the short-term, liquid end of the market on the one hand, and the stock market on the other.
Advantages and disadvantages of stock markets A large number of theoretical and empirical studies have focussed on the investment-employment-growth benefits of stock markets. When risk is spread among a large number of participants through an efficient stock market, closer coordination between the financial and real sector is promoted as well as better sharing of the benefits of economic growth and financial system stability. Risk transfer through debt instruments, in contrast, along with high leverage, weakens the link between the financial and real sector thus posing a threat to financial sector stability. Especially as the growth of pure financial instruments far out-paces the growth of the real sector activities a phenomenon emerges called decoupling whereby finance is no longer anchored in the real sector. The result is financial instability leading to frequent bouts with crises.
If the Islamic rules of market behaviour – such as faithfulness to the terms and conditions of contracts, trust and trustworthiness – are in place in a society, the informational problems and transaction costs, governance, and enforcement issues either would not exist or would be at low levels such as not to create deterrence to stock market entry.
Aside from the fact that, through risk sharing, stock markets become an effective instrument of financing long-term investment, they have the added benefit of being an instrument that individuals and firms can use to insure against liquidity and productivity shocks. While some individual idiosyncratic risks can be mitigated through purchase of insurance policies, such as health, life, and accident, there are potentially a large number of unforeseen, therefore unpredictable, personal or family risks that are not as of yet insurable and for which no insurance policy can be purchased. An individual can buffer against uninsurable risks by buying shares of stocks in good times and selling them when and if a liquidity shock is experienced. Similarly, stock markets can be used to diversify the risk of shock to asset returns. Firms too can use the stock market as a buffer against liquidity and productivity risks. These insurance functions of the stock market create motivation and incentives for investing in projects that have higher returns but lower liquidity.
Empirical studies have demonstrated that countries with robust stock markets rely more on equity and long-term financing and less on banks and short-term debt. Firms place greater reliance on external capital than on internal funds. With a strong stock market, venture capitalists can recoup their capital investment in a project through initial public offerings thus promoting faster rollover of venture capital to make it available more frequently to fi- nance other productive real sector projects. Not only can individuals and firms benefit from the existence of a vibrant and robust stock market that provides risk-sharing opportunities, countries too can benefit from risk-sharing with one another. A large body of empirical research in recent years in the area of international risk sharing has demonstrated that there are gains to be made by countries when they trade in each ther’s securities The question that arises is why is international risk sharing so low? This question is one researcher have been trying to explain in recent years along with another related puzzle called the equity premium puzzle that has been attracting attention since it was first formulated in 1985, It refers to a significant differential existing between stock market returns and the rate of interest paid on a safe bond (US Treasury bonds) over an extended period of time. Economic theory would assert that the differential should not exist. Capital should have left debt instruments and moved into equities until the rates equalised. Hence, the puzzle to be explained is why this high differential continues to persist. The differential cannot be explained by the existing theory of behaviour under risk. Researchers have used varieties of utility functions and risk characteristics, but the puzzle remains largely unexplained. Similarly, there have been at- tempts to explain the low international risk-sharing puzzle but formal modelling has not been fruitful. It is suspected that the reasons which explain low participation in the domestic equity market, hence the emergence of the equity premium puzzle, are the same factors that could explain the low international risk-sharing puzzle. The prime candidate is low trust levels and the high cost of entering the market. Equity markets that are shallow also have limited participation. Empirical evidence suggests one reason for a low participation of the population in the stock market is that people generally do not trust tock markets. Low level of trust, in turn, is explained by institutional factors and education. Moreover, high transaction costs
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- especially information and search costs as well as the high cost of contract enforcement – are crucial factors inhibiting stock market participation. These factors too stem from the institutional rules of behaviour in the economy. Possible reasons for limited stock market participation include:
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- information costs;
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- enforcement costs; and
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- costs due to weak governance structure of firms and markets.
If these costs are prohibitively high, firms will leave the equity market and resort to debt financing through banks. But banks are highly leveraged institutions that borrow short (deposits) and lend long. This maturity mismatch creates potential for liquidity shocks and instability. Even in the case of banks, there are information problems that lead to market failures such as credit rationing which paralyse the opportunity for risky but potentially highly productive projects because they are rationed out of the market.
Conditions for a vibrant, robust stock market
If the Islamic rules of market behaviour – such as faithfulness to the terms and conditions of contracts, trust and trustworthiness – are in place in a society, the informational problems and transaction costs, governance, and enforcement issues either would not exist or would be at low levels such as not to create deterrence to stock market entry.
