Journal Article

This paper investigates the effects of sectoral diversification of loans and financing on the risk and the returns of banks in dual-banking systems. We employ the system GMM estimator on a unique panel data of 46 Islamic and 60 conventional banks from six countries over the period 2000-2015. Our findings reveal that sectoral diversification of loans and financing reduces the returns and increases the risk of both Islamic and conventional banks; the impact of sectoral diversification on returns varies across risk levels, with negative effects at low- and no effect at moderate- and high-risk levels; the difference between the impacts on Islamic and conventional banks across risk levels are marginal, and the adverse effects of sectoral diversification were exacerbated during the 2008 financial crisis. Expansion of loan and financing portfolios into new sectors has no impact on bank returns and risk in our sample. The findings may provide valuable implications for all stakeholders, regulators, and policymakers.

In view of the increasing contributions of social capital in financial development, we examine the relevance of social capital in stock market development by applying Bayesian model averaging on 37 variables across 60 countries from 2000 to 2006. The results demonstrate that trust is a robust and positive determinant of stock market depth and liquidity, and that trust is the most relevant component of social capital in market development. Macroeconomic instability in the form of inflationary changes has a dampening effect on trust in the trading of stock. Further, social capital and its components, particularly trust, are more relevant to stock market development in countries with weak rule of law, non-Organization for Economic Co-operation and Development (non-OECD) and Organization of Islamic Co-operation (OIC) countries that are generally characterized by lower formal institutional quality. Our results seek to reinforce the relevance of social capital in complementing the much needed reform of stock markets globally.

The purpose of this paper is to examine the extent of risk shifting behavior in bonds and sukuk. The examination is significant, as economists and scholars identify risk shifting as the primary cause of the global financial crisis. Yet, the dangers of this debt-financing feature are largely ignored - one needs to only witness the record growth of global debt even after the global financial crisis. To identify the signs of risk shifting existence in the corporations, this paper compares each corporation's operating risk before and after issuing debt. Operating risk or risk of a firm's activities is measured using the volatility of the operating earnings or coefficient variation of earning before interest, tax, depreciation and amortization (EBITDA). Using EBITDA as the variable offers one distinct advantage to using asset volatility as previous research has - EBITDA can be extracted directly from firms' accounting data and is not model-specific.

Before the inception of the Islamic finance industry, there was what could be called a “market failure” in the conventional financial system. There was substantial unmet demand for Shari’a-compliant financial products. Islamic finance grew out of conventional finance to meet this demand. Muslim scholars writing mostly since the 1970s about Islamic finance focused on development of an Islamic finance system; they not only emphasised elimination of riba contracts but urged their replacement with risk-sharing contracts. The practitioners, most of whom had been operating in the conventional finance space, were however interested in developing ways and means of finance that, while Shari’a compatible, would be familiar to and accepted by market players in conventional finance.

While formal institutional quality has been used to explain the finance-growth nexus, the role of social capital has not been fully addressed. The proposition of “better finance, more growth” is important amidst concerns over the erosion of ethics and trust in finance in the aftermath of the 2007/2008 global financial crisis. Using threshold estimation technique, this study examines whether the growth effect of stock market development differs according to the distinct levels of ethical behavior and trustworthiness in a cross-section of 73 jurisdictions during the post-crisis period. The results demonstrate that the impact of stock market liquidity on gross domestic product (GDP) and total factor productivity (TFP) growth is positive and significant only where there is high level of ethical behavior in firms. Similar effect is discerned in the case of strong trustworthiness and confidence. However, there is mixed evidence when formal institutional quality in the form of regulation and supervision of securities exchanges is considered. In terms of policy implications, this study upholds the “better finance, more growth” proposition and contributes to the identification of thresholds above which ethical behavior and trustworthiness can influence positively the relations between stock market development and macroeconomic performance.

Muslim developing countries like many of their conventional counterparts suffer serious indebtedness. Amongst the 57 OIC countries, only the six Gulf cooperation Council countries have positive fiscal balances. The other 51 OIC nations have government budget deficits. Nineteen of these 51 countries are classified by the World Bank/IMF as HIPC (heavily indebted poor country). That government expenditure exceeds government revenues is a fairly common characteristic of developing economics. It is typically the result of the need to fund development. As matters now stand, there are two key problems with this. First, the budget shortfall is typically met by way of interest-based borrowing. Second, as domestic capital accumulation is usually insufficient, governments have to resort to borrowing in foreign currency.

In the last five decades, advances in information technology and in financial innovations have made possible the emergence of an immense capacity for banks to switch regimes from risk transfer to risk shifting. The devastating power of this capacity was amply pronounced in the financial crisis of 2007/2008. The fallout of which has intensified calls for a re-examination of current banking model and its risk management (or rather mismanagement). Risk shifting is, axiomatically, absent in an ideal Islamic financial system. The Islamic banking model, thus, provides unique paradigm with risk sharing at its core, potentially fostering financial inclusion and reducing the incidence of bank failures and the size of losses incurred by depositors and tax payers. However, the present formation of Islamic banking has grown out of conventional banking and reverse engineers many of its techniques and instruments. The main objective of this paper is to empirically investigate risk management in Islamic banks in dual banking systems in member states of the Organization of Islamic Countries. The two-step dynamic difference GMM is applied to cater for the nature of Islamic banking data, which is characterized by a larger dynamic panel and a smaller timeframe. Findings tend to indicate that Islamic banking has a limiting effect on risk shifting. The effect however is not sufficient to fully nullify the overall risk shifting incentives. The evidence supports strengthening risk sharing and reforming Islamic banking configuration as the way forward.

In a risk transfer and shifting financial systems, an interest rate based debt contract is an "impossible contract," since, under the axioms of conventional economics, the borrower has an incentive not to repay the loan. Such impossible contract is made possible by creating a virtual world of certainty through mechanisms such as collateral requirements and an edifice of legal, administrative, policy incentive mechanisms that include positive and negative enforcements that protect the creditor. The society has to bear huge costs to make them possible. Risk sharing has the potential to enhance efficiency as each party to contracts has "skin-in-the-game", thus eliminating or minimizing the principal-agent problem. Participants in a contract of an economic undertaking can choose higher risk-higher return projects thus increase the efficiency and productivity of the system. It can also create a reciprocal and trusting environment that strengthens social cohesion, promotes social mobility and reduces income inequality without perverse incentive effects.

After a millennium of atrophy, Muslims have begun a critical reexamination of Islamic thought in all its dimensions in light of the present state of the world. Arguably the first discipline that began this process during the early decades of last century was political philosophy. Reexamination of economics started much later in the second half of the twentieth century and has continued uninterrupted to the present. There is an ongoing constructive debate among scholars on the fundamental question of whether there is a discipline that can be defined unambiguously as Islamic economics and if so what are its distinguishing characteristics? This presentation is a modest contribution to that debate. It seems reasonable to suggest that any label or prefix that is attached to an economic discipline must bear concrete relationships with economic system that the discipline serves. Thus, disciplines such as socialist economics, capitalist economics, Buddhist economics, Christian economics, Jewish economics, Gandhian economics and others, relate to an envisioned system defined by its characteristics.

The recurring financial crises with the global financial crisis as a latest example have placed the financial markets operating on the basis of interest rate, normally referred as conventional financial markets, under close scrutiny. While some have looked at ways and means to fix the instability inherent in the conventional interest-based system, others have searched for alternative financial systems. In this respect, the Islamic financial system seems to offer a promising avenue for future financial resiliency and stability. However, to date, this view has been largely circulated within professional circles and only recently it has become a topic of academic inquiries.

This paper primarily aims to review and analyze a new model for Islamic finance based on Laurence J. Kotlikoff's idea of limited purpose banking (LPB). In addition, this paper aims to highlight, explain and discuss various aspects of LPB and how it suits the original aspirations of pioneer writers in Islamic finance. Based on an extensive literature review, this paper aims to highlight, explain and discuss the reform of the Islamic finance industry based on Kotlikoff's model of LPB. Based on a modified LPB model, Islamic financial institutions could be established to provide specific services with clear aims and objectives. These LPB Islamic financial institutions would operate in a similar way to LPB. As there is no perfect plan, the proposal of this paper is far from being perfect and is open to discussions and improvements. The paper will, hopefully, spark off quite a discussion on the topic; may result in a better understanding of the model; and provide some alternative solutions to the current structurally ill financial system. The paper provides some practical ideas for a better implementation of Shari'ah principles in financial intermediation of the Islamic financial system. Kotlikoff's LPB proposal for reforming the financial system is new and has been directed to the conventional financial system. This paper represents the first attempt to apply his proposal to the Islamic finance industry.

The purpose of this paper is to set forth seven broad recommendations and 15 specific initiatives within a four-dimensional framework for the development of social capital in Islamic finance, particularly the stock market, given its role as the first best means of risk sharing. The four-dimensional framework comprises dimensions of principle and value, trust-reinforcing regulation, investment opportunity and infrastructure, as well as reputational intermediaries. A web of multi-pronged initiatives that are mutually reinforcing is proposed considering the multifaceted dimensions of social capital and the various possible transmission channels by which social capital can influence the financial system. While empirical studies have demonstrated the importance of trust and ethics in financial development, the pressing issue remains how social capital, including trust and ethics, can be developed to achieve a trustworthy, ethical and efficient financial system. This paper attempts to address this concern.

In an Islamic economy, the financial sector functions to support the real sector. There are no interest rate based debt instruments. Financial assets are based on risk and return sharing and are contingent claims. Real as well as monetary forces determine the rate of return. As in traditional general equilibrium theory, there is a price system comprised of a real rate of return to capital and a price level of commodities that simultaneously clears asset and commodity markets. An Islamic financial system is shown to be stable, namely the economy evolves from short-term equilibrium to a stable long-term equilibrium.

This paper aims to critically investigate the liquidity risk management of Islamic banks and develop an alternative regulatory framework appropriate for liquidity management of these banks. The specific risk profile of an Islamic bank requires developing a new and more efficient regulatory framework, which relies on risk-sharing and symmetric information among parties. The paper makes a differentiation between small local banks and internationally active Islamic banks and proposes to apply liquidity requirements only for internationally active Islamic banks. A new proposal for the liquidity coverage ratio (LCR) of Islamic banks is developed in this paper towards mitigating risks and concurrently protecting the interests of investment account holders. Minimum and maximum thresholds are proposed for each liquid asset in this new LCR framework. An alternative liquidity approach is discussed to complement the proposal and several policy options are suggested.

This paper attempts to set out the principal issues that need to be resolved in formulating a proposal for quotas and voice reform in the IMF that could command broad support. Following John Rawls, we argue that “justice is the first virtue of social institutions,” and we use his theory of justice to provide a method for understanding what should be the case, in the context of voice and voting shares, before international institutions, such as the IMF, are to be justifiable to their members. The implementation of this process suggests, among other things, that a major revision of the quota formulas is long overdue, and leaving this unaddressed raises serious questions regarding the IMF’s governance which could develop into a core mission risk and jeopardize the relevance of the institution.

Dominant macroeconomic policy regimes are anchored on the interest based debt finance that has created a divergence between the real sector and the financial sector of the economy. Uncertainty has been growing regarding the adequacy of current policy regimes to provide sustainable solutions to contemporary economic problems and challenges, including improvement in the quality of life in addition to the traditional objective of achieving growth with price stability. Policy tools that provide an incentive structure for closing the gap between financial and real sectors of the economy and at the same time enhance social solidarity through the mutual sharing of risks and return could provide more effective means of addressing these challenges. This concept paper offers an alternative policy regime that proposes first, a monetary policy that is targeted directly at asset market activities and private sector portfolio adjustments. Secondly, it suggests mobilization of funds for financing fiscal operations based on risk sharing through sale of government low-denomination equity participation papers directly to the public tradable in secondary markets. The latter proposal is supplemented with a reform of the tax structure. The benefits include better return to savers, improved financial inclusion through broadened public participation, improved governance and positive distributional implications for current and future generations. The objective of these policy reforms is to achieve stability and growth of the real economy, without losing sight of the goal of achieving justice and equity among members of the society.

This paper argues that risk sharing is an effective method of expanding participation of agents in economic growth and development and more effective sharing of fruits of prosperity than risk transfer that currently dominates financial systems. Kuala Lumpur Declaration of 2012, by a group of leading Shari'ah scholars and Muslim economists, considers risk sharing as the essence of Islamic finance, a litmus test of which is its ability to promote financial inclusion and asset-building capacity of the poor and thus better sharing of prosperity. The mobilisation of financial resources toward productive activities through risk sharing enables the Islamic financial system to actualize economic justice and social participation in an efficient manner. The asset-backed equity-financing nature of Islamic finance is conducive to financial system stability because returns, which can only be known ex post, and thus shared on the same basis, are not divorced from risk.

The risk sharing principles of Islamic finance as embodied in mudarabah and musharakah contracts have been extensively used throughout history. For example, the maritime trades of 14th century Italian city-states with Middle East and Asia were financed by ‘sea loans' and ‘commenda’. Historians have traced the development of commenda to borrowing from the concept of mudarabah used by Muslims (Udovitch, 1962; 1967; 1970; Mirakhor, 2003). They have also recorded how crucially important these contracts were to the growth of not only the maritime trade but also to the economic, social and political progress of European city-states.

A major reason for the recurrent episodes of financial instability is the predominance of interest-based debt and leveraging. Financial stability is achievable through risk sharing finance instead of risk shifting that characterizes contemporary finance. A risk sharing system serves the true function of finance as facilitator of real sector activities and avoids the emergence of a “paper economy” where there is gradual decoupling of finance from the real sector. Islamic finance was initially proposed as a profit-loss sharing system, but its core principle is risk sharing. In prohibiting interest-based debt instruments, Islam grounds finance on a strong risk sharing footing. Although still a young industry that has come a long way, it has not managed to develop truly risk-sharing instruments that would allow individuals, households, and firms as well as whole economies to mitigate systematic and un-systematic risks. It is suggested that governments should intervene and issue macro-market instruments to provide their treasuries with a significant source of non-interest rate based financing while promoting risk sharing. Moreover, given that evidence across the world suggests that monetary policy’s transmission mechanism may be impaired, it is suggested that these government issued securities could also impart added potency to monetary policy.

With cross-section data from 53 emerging and mature markets, we provide evidence that equity premium puzzle is a global phenomenon. In addition to risk aversion, equity premium may reflect ambiguity aversion. We explore the sources of equity premium using some pertinent fundamental independent variables, as well as the World Bank institutional quality indexes and other proxies for the degree of ambiguity in the sample countries. Some World Bank and other indexes are statistically significant, which indicates that a large part of equity premium may reflect investor aversion to ambiguities resulting from institutional weaknesses. Implications of the results for Islamic finance are discussed.

Economic and financial crimes, defined generally as crimes against property, have been increasing rapidly in recent years. In the 2014 Global Economic Crime Survey it is noted that among the 5,000 business organisations across the world responding, 37 percent report being victims of economic crime, up from 30 percent in 2009. No country, society, culture or community has been immune. The financial crisis focused attention on elite white-collar crimes while empirical research was pointing to another alarming development: “the everyday crimes of the middle class”, committed by those “[...} at the very core of contemporary society” (Karstedt and Farrall, 2007).