Financial Engineering and Evaluation of New Instruments

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Financial Engineering and Evaluation of New
Instruments

• Dr. Munawar Iqbal
• Chief of Research (Islamic Banking and Finance)
• IRTI, Islamic Development Bank
• DLC Lecture
• November, 2004

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Definition of Financial Engineering

• Financial engineering can be defined as the
  design, development, and the implementation of
  innovative financial instruments and processes,
  and the formulation of creative solutions to
  problems in finance.

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Need for Financial Engineering in Islamic Finance

• Until now, the Islamic financial tools have
  essentially been limited to classical modes
  developed centuries ago. They were developed to
  meet the needs of those societies. While they may
  serve as useful guidelines for contemporary
  Islamic contracts, there is no reason to be
  restricted only to those. Financial markets are
  becoming more and more sophisticated, and
  competitive. In order to exploit the fast
  changing market environment and face increasing
  competition, financial engineering and innovation
  is imperative.

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Scope for Financial Engineering in Islamic Finance

• Financial needs of both individuals and
  businesses have changed. Engineers in modern
  finance have designed several new ways such as
  mortgages, options, derivatives, hedging,
  insurance pension plans, credit cards etc., to
  meet those needs. We must examine what needs are
  being fulfilled by these instruments. If the
  needs are genuine (Islamically speaking), then we
  must either adapt them for our purposes or invent
  Islamic alternatives for them.

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Scope for Financial Engineering in Islamic
Finance-Cont.

• In the light of the principles of maslaha and
  istihsan, a needs approach to financial
  engineering is desirable, of course within the
  known principles of Islamic finance. In this
  regard, the example of bay salam is very
  important to remember. In general, it is not
  allowed to sell anything, which is not in ones
  possession. But in case of salam, the Prophet
  (pbuh) allowed such sale because of need of the
  people, but laid down clear rules to protect the
  interests of both parties.

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Scope for Financial Engineering in Islamic
Finance-Cont.

• The process of adaptation is well recognized in
  Islamic fiqh and has never stopped. However, its
  speed needs to be greatly enhanced. Classical
  contracts have been modified in a number of cases
  to meet current needs. One potent example is the
  initiation of Islamic banking on the basis of
  al-mudarib udarib principle, which provides that
  a mudarib (agent) may himself appoint another
  agent to actually run the business. Another is
  the practice of murabahah, through which the bank
  buys merchandize upon the promise of another
  party to purchase it from the bank at a higher
  price.

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Scope for Financial Engineering in Islamic
Finance-Cont.

• The principle of al-mudarib udarib essentially
  allows for sub-contracting. If the principle is
  acceptable, there is no reason to restrict it
  only to mudarabah. Contracts can also be designed
  on the basis of other principles, like al-muajjar
  uajjir, al mustasna yastasna, etc. In other
  words, the original contractee may arrange to
  fulfil the obligations under the contract through
  third parties. That the principle is acceptable
  from an Islamic point of view is not
  questionable.

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Scope for Financial Engineering in Islamic
Finance-Cont.

• While it is possible to modify classical
  contracts to suit modern conditions, a much
  broader scope for financial engineering exists in
  developing new contracts. These contracts could
  be hybrids of old contracts or may be entirely
  new. The scope for financial engineering, and for
  that matter for innovations in other fields, is
  quite wide. It is important that the task is
  given over to those experts who know the needs
  and niceties of the trade.

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Two kinds of Ahkam

• Ibadat and Muamalat
• The general principal in case of ibadat is that
  nothing is that an act is ibadah only when
  permitted by God.

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The Doctrine of Original Permissibility

• In case of muamalat, the general principal is
  that of ibaha, i.e. everything is permitted
  unless clearly prohibited by God. We call this
  the Doctrine of Original Permissibility.
• For prohibitions, Shariah provides general
  guidelines to be observed. The interpretation of
  these guidelines in every age is done through the
  process of ijtehad.

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Guidance From Quran on Business Dealings

• ?? ???? ????? ????? ???????? ??????? ?????
  ??????? ??? ?? ???? ????? ?? ???? ????.
• )???? ??????? ????? 29(.
• O Ye who believe! Eat not up your property among
  yourselves unduly. Let it be trade amongst you by
  mutual agreement.
• This verse is perhaps the most important verse of
  Quran on economic matters. It tells us both the
  dos and the donts in business dealings.
• First the donts.

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What is Prohibited in Business Relations

• The verse rules out ALL illegal ways of wealth
  creation. Batil encompasses any way of
  acquiring wealth that violates the rights of
• (a) God
• (b) Contracting Parties and
• (c) Third Parties
•  

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Prohibitions-I

• First and foremost those ways of wealth creation
  are ruled out that are declared illegal by the
  Supreme Law Giver. Examples of these are riba,
  gharar, qimar.

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Prohibitions-II

• The scope of the verse also includes all those
  activities, which are declared illegal by the
  state and its various echelons. Examples of these
  are bribery, smuggling, money laundering.

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Prohibitions-III

• Ways of creating wealth that violate the rights
  of third parties are also prohibited. Examples of
  these are creating pollution, obstructing common
  passage ways and other negative externalities.
  Zoning regulations by municipalities are covered
  here

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Kinds of Contracts

• Islamic contracts can be broadly classified into
  two categories
• Charity (Tabarruat) and
• Exchange (Muawadat).
• In this lecture our interest is in the latter.

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Guidelines for Financial Contract Design

• Freedom in determining the conditions of a
  contract within Shariah rules.
• Prohibition of taking others property without
  compensation
• Conscious Agreement within Shariah limits
• Mutual Benefit (Value Equivalence)
• Justice and Fairness (Elimination of Exploitative
  Clauses)
• Provision of Maximum Possible Information
• Honouring the Spirit of Contract

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What is Allowed in Business Contracts

• The Golden Principle of Free Choice
• ???????? ??? ?????? ??? ???? ??? ????? ?? ???
  ?????
• Muslims are free to determine the conditions of
  their contracts unless they make something
  forbidden as permissible or something permissible
  as forbidden
• In Islamic theory of contracts, parties are free
  to agree on any terms as long as known Islamic
  rules and principles are not violated.

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Financial Contracts Special Conditions to be
Observed

• Prohibition of Riba
• Prohibition of Gharar
• Prohibition of Gambling

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Prohibition of Riba

• Riba literally means increase, addition,
  expansion or growth.
• In the Shariah , however, the term riba refers
  to anything (big or small), pecuniary or
  non-pecuniary, in excess of the principal in a
  loan that must be paid by the borrower to the
  lender along with the principal as a condition of
  the loan or for an extension in its maturity.
• In this sense, Riba has the same meaning and
  import as the contemporary concept of interest in
  accordance with the consensus of all the fuqaha
  (jurists).

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Prohibition of Gharar

• Gharar refers to act and conditions in contracts,
  the full implications of which are not clearly
  known to the parties.
•  In economic parlance it is very close to
  Asymmetric Information.
• It has two kinds gharar yaseer (trivial) and
  gharar fahish (substantial).
• The first kind is tolerated since this may be
  unavoidable without causing considerable damage
  to one of the parties.

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Prohibition of Gambling (Maysar)

• ?? ???? ????? ????? ???? ????? ??????? ????????
  ???????? ??? ?? ??? ??????? ???????? ????? ??????
  (???? ???????? ?????90(.
• O Ye who believe, Intoxicants and Gambling,
  (Dedication of ) stones, And (Dedication of)
  arrows, are an abomination, of Satans handiwork
  Eschew such (abomination) , That ye may prosper.
• Gambling amounts to transfer of wealth without
  any value added.

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Some Relevant General Principles of Shariah

• No pain no gain (Al- Kharaju Bil-Daman)
• Principle of Relief (Istahsan)
• Doctrine of Necessity (Dharoorah)

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The Four Cs of Islamic Financial Engineering

• In addition to the Doctrine of Original
  Permissibility and the Golden Principle of Free
  Choice and the discussion of the few
  prohibitions, we can summarize the guidelines for
  financial engineering in what we call Four Cs of
  Islamic Financial Engineering. These are
• Consciousness
• Clarity
• Capability
• Commitment

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Consciousness

• That the parties should consciously and willingly
  agree on the conditions of contract without
  compulsion or duress. An implication of this is
  that any agreement made in the state of
  unconsciousness (like under the influence of
  intoxicants or imposed by force ) is not valid.

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Clarity

• That the parties are fully aware of all the
  implications of the conditions laid down in a
  contract. Any ambiguity (with the exception of
  gharar yasir) will make the agreement invalid. An
  implication is to minimize asymmetric informatiom.

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Capability

• That the parties are reasonably certain that they
  are capable of complying with all conditions of
  the contract. An implication of this is that sale
  of any goods (or services) which are not owned
  and possessed by the seller at the time of the
  contract is not valid.

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Commitment

• That the parties intend and are committed to
  respect the terms of a contract both in letter
  and spirit. An implication of this is that any
  subterfuge to go around any Shariah condition
  through linguistic or legal tricks is not allowed.

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Comments on Some Recent Contracts

• Sukuk
• Tawarruq