Risky asset management for shared prosperity

(This article was first published in Islamic Finance news Volume 17 Issue 9 dated the 4 March 2020)

During a recent talk at the biggest Islamic cooperative bank in Malaysia, Bank Rakyat, DR MARIZAH MINHAT and DR NAZAM DZOLKARNAINI elaborated on the role of Islamic finance in sustaining the Shared Prosperity Vision 2030 that was launched by the then-prime minister Dr Mahathir Mohamad on the 5th October 2019. The vision is in line with the 2030 Agenda for Sustainable Development Goals (SDG 2030) adopted by all UN member states.

We argued that shared prosperity is only a myth with financial exclusion and perverse incentives continuing to widen the gap between the rich and the poor. Talking at the ‘Our Sustainable Planet Series’ hosted by Bank Rakyat, we shared research findings that question the progress of Islamic banking in improving financial inclusion. Based on data from 80 countries, little evidence was found that Islamic banking has improved on this aspect. The findings call for more work to be done by Islamic banks in sustaining the Shared Prosperity Vision, hereafter referred to as the SPV.

Central to this effort is a paradigm shift and incentives to manage risky assets through the sharing principle. Sharing is indeed a key element of the SPV. Risky assets include investments in permissible real assets, business ventures and financial assets that are expected to generate income, hence prosperity. Loans (as replicated in various terms such as Murabahah and Tawarruq) typically dominate a bank’s portfolio of financial assets.

We suggest that risk associated with assets to be shared proportionately according to the underlying performance. Income should commensurate with the current value of performance rather than being fixed as a certain percentage of the par value or historical value of assets.

Allowing Islamic banks to earn a fixed income through financing risky assets, as in the case of Murabahah as currently practiced, is hardly consistent with the SPV. In this contract, banks are entitled to income irrespective of the performance of the underlying risky assets they finance. Limiting a bank’s exposure to risk by fixing its income in this way deviates from the sharing principle that underlies the SPV.

By implication, a bank will continue to prosper while an entrepreneur will suffer when a business venture fails. For example, the following condition is imposed by an Islamic financing facility currently in offer for entrepreneurs to develop their business: “The customer is responsible to ensure that the installments are paid according to the agreement even when the customer is facing financial problems such as losses of business or illness.”

Ironically, entrepreneurs (or borrowers) from an underprivileged background will suffer more in unfortunate circumstances. People from underprivileged or ‘subprime’ backgrounds (ie no income, no jobs and assets) are discriminated against in credit risk models. Such a profile if not excluded from the financial markets will attract greater credit risk premium which is an opportunity to fix a higher financing income for banks.

In this system, the poor is either excluded or has to pay a greater cost of financing than what is paid by the rich. Is deriving income based on credit risk consistent with the teachings of Islam? For sure, Islam does not teach us to exploit the poor.

Generating income and profit is permitted but profiting by exploiting those from underprivileged backgrounds is hardly consistent with humanity. Profitability is only one performance measure of prosperity, not humanity. Although many have argued that profit is the bottom line and cash is king, humanity will cease to exist if values such as sharing disappear from the planet. “Sharing is caring,” they say. But to what extent we are willing to share risk is often questionable.

According to the prospect theory, we are generally risk-averse and prefer a guaranteed return on investment. However, a risk-free investment is akin to a ‘comfort zone’ that could breed the moral hazard of being idle. Although arbitrage profit by exploiting information asymmetry and ignorance of others is profitable, is it ethical?

More Rizq (ie prosperity) comes with greater responsibility. Likewise, return and risk are positively related. By implication, if a bank and its shareholders (or cooperative members) are genuinely interested in maximizing returns from their investment in risky assets, they should be willing to bear a proportionate share of the risk associated with those assets. Little appetite for risk-sharing limits income to a fixed rent rather than a greater return on investment. Therefore, the risk minimization strategy is out of sync with the return maximization agenda.

If maximization of returns is no longer relevant, expecting a fixed and stable flow of income hardly reflects the willingness to sustain the SPV. Only if banks’ shareholders (or cooperative members) are willing to jointly share the risk (and losses) with the underprivileged segment of the society, will the SPV be sustainable.

As better resourced entities, banks should be more competent and capable of assuming greater risks compared to their underprivileged partners. The responsibility to form partnerships with entrepreneurs from underprivileged communities is indeed greater for financially sound banks as resources are meant to be shared with the wider community rather than being hoarded within the circle of the selected rich.

Installing a sharing instrument is an ideal asset management strategy to sustain the SPV. The proper use of instruments such as Musharakah will regulate banks and their shareholders (or cooperative members) to share not just profits but also losses resulting from underperforming underlying assets or ventures they have jointly invested in. However, this instrument has not been popular.

Our proposal requires a paradigm shift where banks are expected to take on beyond credit risk and work in partnership with other stakeholders. Gaining ‘skin in the game’ through greater risk exposure will incentivize banks to strengthen their talent and competency development in asset management. This proposal also requires the remuneration of banks’ directors, management and employees to be linked to the growth and performance of Musharakah in banks’ portfolios of assets. Also, directors’ remuneration should be monitored to curb excessive pay that is not commensurate with performance.

The challenge here is to embrace not just profit-sharing but also risk- (and loss-) sharing to incentivize a better asset management strategy and link it to directors’ and management’s remuneration as well as dividend payments to shareholders (or cooperative members). For a sustainable SPV, these stakeholders should be willing to jointly experience ups and downs and prosper together following natural law.

Much has been said. Let us now walk the talk.