From the discussion we had so far on the subject of risk, it can be deduced that in the conventional financial world, a risk can be conveniently shifted whereas in Islamic finance, you must learn to live with it.
How is the risk shifted in a conventional financial transaction? There are various ways to do so, including by way of securitization of customers’ debt obligations (mortgages, credit cards, personal loans, etc) or by purchasing the credit default swap. Such risk-shifting is not permissible in Islamic finance since Shariah prohibits the transfer of risks and encourages sharing them between the parties of a transaction, ie the Islamic financial institution and its customer.
In the Islamic financing modes discussed last week which result in a debt obligation on the customer, one may argue that the ownership risk is transferred from the financial institution to the customer and the institution is merely exposed to the credit risk — similar to a conventional financial institution.
This argument will not be correct since the risk is not transferred by way of direct lending (on interest of course) as what the conventional financial institutions do, but by way of first purchasing a commodity and hence acquiring the title and possession in a Murabahah, Istisnah or Salam contract and at the same time getting exposed to the ownership risk, and then selling the commodity to the customer on a deferred basis. In other words, the financial institution first bears ownership, market and any other risk directly associated with the commodity (no matter for how short the period) and then transfers the commodity to the customer with ownership and all other risks against acquiring the credit risk.
On the other hand, in conventional practice the risk is transferred separately without any relation to a commodity as if the risk is a tradable commodity in itself. Shariah principles state that the risk in itself is not tradable and cannot be shifted in the same manner as the debts are not tradable.
It is however permissible that the risk is borne voluntarily as explained last week in reference to the opinion of Maliki jurists, where the risk in Tabarru’ (donation/gift) is permissible in spite of the involvement of all types of prohibited risks. This is because the one who is being promised a donation or gift shall not be making any payment for it.
Hedging is a tool to achieve a purpose that is to manage, eliminate or mitigate a risk. In conventional financial practices, there is no restriction on the nature and extent of the risk taken and then shifted. They first deal in transactions that involve excessive risks and then adopt means to shift them which in itself involves excessive risk, speculation and uncertainty to the economy. This is a vicious cycle which harms financial growth and leads to a severe financial crisis as has been seen many times. Moreover, the funds used in such tools are not invested to produce, create or increase the real economic wealth in society.
Islamic financial institutions do not enter into such transactions which involve excessive risks and therefore, they may comfortably adopt means to mitigate risks they share or bear within the parameters of Shariah and without any harm to the economy. However, it is possible that at the time of developing a product, efforts are made to prefer a structure which has lesser risks or is self-mitigated and at the same time fulfills Shariah requirements.
One should always keep in mind that the types of risks, their nature and their classification in Islamic finance are totally different from conventional finance. Therefore, the conventional risk management techniques may not always be ideally applicable on Islamic financial institutions.
The Islamic modes of investment and financing which are based on the Shariah maxim that the risk follows the return and the benefit should directly be related to liability and a total or partial loss or decrease in value of an asset is on account of its owner. Therefore, the so-called hedging is permissible in Shariah if the following conditions are met:
• The risks being managed/mitigated themselves must be Shariah compliant
• Risk management should be by way of Shariah compliant means, modes and contracts, and
• The objective should only be managing, mitigating or lowering the risk and not eliminating it altogether or to earn profit by making these as regular financial products without any real hedging need.
Whatever the tools adopted to manage the various types of risk in an Islamic financial transaction, the following basic Shariah principles should never be compromised:
• The tools being adopted to manage the risks should not breach the principle of Al Ghunmu Bil Ghurm (return is linked to liability) and should only aim at minimizing or lowering the risks
• The tools should not involve excessive risks in themselves, and
• The tools themselves should be Shariah compliant so as to mitigate those risks which Shariah allows to mitigate or avoid.
• If certain risks cannot be mitigated, these should be left untouched so as not to spoil the Islamic transaction.
The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions of the Dubai Islamic Economy Development Centre, nor the official policy or position of the government of the UAE or any of its entities. The purpose of this article is not to hurt any religious sentiments either consciously or even unwittingly.
Sohail Zubairi is the senior advisor with the Dubai Islamic Economy Development Centre. He can be contacted at [email protected]
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