Hylmun Izhar

Towards a Viable Musharakah Instrument: A Regulatory Perspective

ackground

hat is it

ow is it implemented

hat is the desired impact

ationale for Financial Regulation Perspective to Ponder

Background

Sustained global imbalances are in a much bigger problem when they are financed (overtly or covertly) by debt instruments, whether it be bank lending, bond lending or even official lending.

It is debt markets, that lie at the center of most financial crises. To reduce the risk of financial crisis, policymakers need to create a system where contingent claims play a far larger role, and where pure debt instruments play a correspondingly smaller role.

Doctors have long known that it is not just how much you eat, but what you eat, that contributes to or diminishes your health.

Likewise, economists have long noted that for countries gorging on capital inflows, there is a big difference between debt instruments and equity-like investments, including both stocks and foreign direct investment.

Kenneth Rogoff, Project Syndicate, March 2011: Western policymakers and economists often portray Islamic financial systems, with their emphasis on shared risk and responsibility in lending, as less efficient than western systems that put no strictures on debt. Yet one can equally argue that Western financial intermediation is far too skewed towards debt, and as a consequence generate many unnecessary risks. Kenneth Rogoff, International Symposium in Banque de France, March 2011: Perhaps scholars who argue that Islamic financial systems prohibition on interest generates massive inefficiencies ought to be looking at these systems for positive ideas that Western policymakers might adopt.

What is it? Mushrakah is an agreement between the IIFS and a customer to contribute capital in various proportions to an enterprise, whether existing or new, or to ownership of a real estate or moveable asset, either on a permanent basis, or on a diminishing basis where the customer progressively buys out the share of the IIFS (Diminishing Mushrakah). Profits generated by that enterprise or real estate/asset are shared in accordance with the terms of Mushrakah agreement whilst losses are shared in proportion to the respective contributors share of capital (IFSB, 2005).

Musharakah

Musharakah Contract

Financial contribution

Contribution

Principal

Agent

Capital and Effort

Capital

Profit

Agent

Capital

Loss

Musharakah Contract

Financial consequences

Profit

Principal

Agent

Fee and profit share

Profit share

Loss

Loss share

Loss share

Profit

Agent

Capital

Loss

Musharakah Contract

Implementation

Banking

Takaful

Capital market

Assets

Invest Acc

Investment

Invest Acc

Investment

Source: Zhou Tao, Shanghai Daily

Desired Impact

Financial Regulation

To maintain public confidence by keeping sound market integrity.

To contribute to the protection and enhancement of stability of the financial system

Objectives

Financial Regulation

Regulation is about changing the behaviour of regulated institutions.

One key issue is the extent to which behaviour is to be altered by way of externally imposed rules, or through creating incentives for financial institutions to behave in a particular way.

A major issue, therefore, is whether regulation should proceed through externally imposed, prescriptive and detailed rules, or by the regulator creating incentives for appropriate behaviour. Regulation can usefully be seen in terms of a set of contracts.

Financial Regulation

Laws, regulations, and supervisory actions provide incentives for regulated firms to adjust their actions and behaviour, and to control their own risks internally.

They can usefully be viewed as incentive contracts within a standard principal-agent relationship where the principal is the regulator, and the agent is the regulated firm.

Within this framework, regulation involves a process of creating incentive compatible contracts so that regulated firms have an incentive to behave in a way consistent with the social objectives of systemic stability and investor protection.

If incentive contracts are well designed they will induce appropriate behaviour by regulated financial intitutions.

A Perspective to Ponder

Let us not get overwhelmed by the idea of shifting to entirely risk sharing proposition without having a comprehensive analysis which can be justified methodologically.

Therefore, identification of optimal portfolio diversification based on the current state of the industry is needed.

Such an effort, hence, should be combined with the development of incentive based regulation.

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