How do we convert real hard assets into financial products? Banks by definition do not trade in real hard assets, they trade in financial products that are linked to real assets. Normal bank loans are linked to either one of the two: future income streams of a borrower, or future revenue generated from an asset that is financed. Bank loans are therefore linked directly to a stream of income, which may be linked to an intangible asset like a borrower’s skill, or may be linked to a tangible asset like a factory machine, which produces goods and services. Bank loans are rarely disbursed merely on the value of the collateral provided by a borrower.
The same holds for Islamic banking, which to date is still a credit sale-based financing system as is much of the global banking system. How can financial products, or paper products be engineered such that the parties to the product benefit in a manner that ‘mirrors’ the behavior of a real good or product or asset? For instance, banks are not in the business of buying inventories of aluminium at a cost price and then selling it onward for a profit to a third party. But banks are in the business of trading in aluminium futures contracts which allows them (the banks) to benefit from movements in the real prices of the real asset. What if a product was devised between Bank A and Party B, where B agrees (for a consideration of US$0.1 paid by the bank), to pay the bank US$2, if the price of copper goes up by 5% within a specific time frame, in a specific market, such as the London Mercantile Exchange? If this product looks rather vague, have a closer look at investing in commodities indexes. Needless to say, B charges a fee for this contract or promise. If the price of copper does go up by 5%, B pays Bank A US$2; if the price of copper does not go up by 5%, B retains the US$0.1 fees. These products closely resemble the end result of options trades, and cash-settled futures transactions. There is no desire, will, or intent to hold any asset, but just to benefit from the movements in prices of an underlying asset, which in this case is aluminium.
Banks may not be able to buy houses directly, but benefit indirectly from the real estate market by the interest income earned from financing the purchase of houses. The higher the prices of houses go, the higher the amount of loans banks will extend and therefore earn higher interest. Real estate brokers earn higher commissions, sellers earn higher profits, buyers get squeezed and banks earn higher interest income. However, banks participate in the real estate market not as purchasers of homes but financiers of homes. The value of the loans extended are obviously linked to the values of the homes financed, but banks do not make income from the differences between cost prices and selling prices of real estate assets; they enjoy a fixed or floating income from interest payments made by borrowers. However, is it possible to structure financial products in which banks are allowed to make investments that offer returns much like capital returns on buying and selling houses?
Banks are always on the lookout for additional sources of income, and in an environment of decreasing interest rates, banks in the developed world have been hard-pressed to find ways of benefiting from an array of economic activity, to which traditionally they have not had direct involvement in. Can banks benefit from the price appreciation of houses on Edgeware Road in London for instance? Only if banks take depositors’ money and buy houses with it. This is not permissible by regulators. Imagine a bank that extends a loan to a customer for US$1 million to buy a house in London at an interest rate of just 3% for 20 years. Keeping the math very simple, the bank will earn only US$30,000 in interest income per year, hardly enough to pay the mortgage officer’s salary. If this very same home sells for US$1.5 million in two years, the owner of the home will make a profit of US$500,000, probably pre-pay the loan and make a tidy profit at the end of the day. The bank would not have benefited from the price appreciation of the asset, and suffers from a pre-paid loan. Unless the new buyer also finances the purchase of the house from the same bank, the bank in fact stands to lose more than benefit from the appreciation in price of the underlying house. The question arises, as to how banks can hedge against such risks, and if possible benefit from such events. Can banks develop products that offer returns linked to the appreciation in the price of an underlying asset such as homes? The answer is yes. These products are called synthetic products that behave like real assets.
We will study some of the products in this book and look at the incentive behind purchasing such financial products and determine if they play any positive role in Islamic finance.