Islamic finance: Risk-sharing as sustainable risk management
(This article was first published in Islamic Finance news Volume 15 Issue 8 dated the 21st February 2018)
Risk and return are two sides of the same coin. Risk is recognized as a source of return except for risk-free investments. According to the capital asset pricing model, risk is a determinant of return expected from an investment. Interestingly, the Arabic term Rizq (as expressed in the Quran) is defined as sustenance from Allah. It includes the provision of sustenance that includes food, property, offspring and knowledge. Rizq is not limited to financial benefits and it entails responsibility. For example, verse 3 of Surah Al-Baqarah is a reminder of the responsibility of one to help others out of what Allah provides for them as sustenance.
However, investors are naturally more interested in maximizing financial returns while minimizing risk. Given two investments with identical returns, risk-averse investors will choose the investment with lower risk. Arbitrageurs are not interested in risk-bearing at all in their pursuit of arbitrage profit. The attempt to decouple return from risk, or the need to reduce exposure to risk, has given rise to risk management activities. Risk management has advanced through the trading of risk that often involved speculators as counterparties.
Credit risk grows with debt financing. The financial crisis that erupted in 2007 was just another reminder of a disastrous consequence of failing to manage credit risk. Charging interest and risk-shifting are basic conventional credit risk management strategies. In debt financing, a borrower’s default risk is borne by a financier who in turn would require risk management. Charging interest is dubbed as a compensation for the financier for bearing the borrower’s default risk. The interest is often fixed at a certain percentage of the principal amount of the underlying debt. Greater default risk will attract a greater percentage of interest as compensation for greater risk-bearing. A wealthy well connected borrower may have a greater ability to access a cheaper cost of financing, while a subprime borrower without capital is associated with greater default risk that would yield greater interest income for the financier.
Financiers are interested to maximize interest income but are less willing to bear corresponding credit risk. This gave rise to the risk-shifting strategy that advanced with the significant growth of the credit derivatives market since the 1997 Asian financial crisis. According to the British Bankers Association, the size of the global credit derivatives market had grown from US$350 billion in 1998 to US$33 trillion in 2008. Credit default swaps (CDS) were identified as a major component of the global credit derivatives market. CDS allow the transfer of the borrower’s credit risk from a financier to a CDS seller. The contract is a promise of the CDS seller to protect the CDS buyer against the underlying default risk.
Although we can expect that the financier was motivated by a hedging motive, it is not impossible for the CDS seller to be induced by a speculative motive. Speculation will remain speculation despite being informed by advanced complex mathematical or statistical models. It is widely acknowledged in the literature on risk management that the quality of statistical risk models is much lower than often assumed. Selling CDS was once considered as ‘gold’ and ‘free money’ because risk models indicated that the underlying securities will not default. Unfortunately, what was believed as an arbitrage opportunity turned out as a driver for bankruptcy due to the underestimation of excessive exposure to credit risk. In particular, the inability of the American International Group to fulfil the ‘promise to protect’ had triggered a systemic liquidity crisis. A recent study found that the extent of CDS held for hedging is positively related to default risk in the period leading to a financial crisis. Both the anecdotal and empirical evidence casts doubt on the sustainability of the risk-shifting strategy.
Risk-shifting as a risk management strategy as described previously is certainly not to be replicated in the Islamic financial system. Credit risk cannot be legitimately priced in the form of interest and cannot be traded through derivatives such as CDS. Credit risk is indeed not relevant in the context of profit and loss/risk-sharing (PLS) financing as promoted in Islamic finance. There are at least three advantages to this financing strategy: (1) the financier is not exposed to credit risk hence there is no requirement to manage credit risk; (2) PLS financing incentivizes a financier to actively monitor the underlying (permitted) investment project, and (3) the financier is entitled to an unlimited upside potential of returns, rather than returns limited to an (predetermined) interest rate.
In PLS financing, a legitimate return is derived from bearing real risk, not financial risk such as credit risk. Islamic finance promotes the sharing of risk that is associated with a permitted real investment project. Risk-sharing is the essence of risk management in Islamic finance. Risk-sharing and profit-sharing are two sides of the same coin. A disproportionate return or risk is extravagance. One can learn from the previous episode of financial crisis that credit risk-shifting is not a sustainable risk management strategy because it is capable of fueling a credit bubble and systemic risk. Debt financing is permitted if financiers are willing to forgo interest and forgive debt (if need be) as an investment for the hereafter. Verse 280 of Surah Al-Baqarah states: “If, however, [the debtor] is in straitened circumstances, [grant him] a delay until a time of ease; and it would be for your own good – if you but knew it – to remit [the debt entirely] by way of charity.”
