Financial Engineering and
Evaluation of New Instruments
Dr. Munawar Iqbal
Chief of Research (Islamic Banking and Finance)
IRTI, Islamic Development Bank
DLC Lecture
November, 2004
1
Definition of Financial Engineering
Financial engineering can be defined as ‘the
design, development, and the implementation
of innovative financial instruments and
processes, and the formulation of creative
solutions to problems in finance’.
2
Need for Financial Engineering in
Islamic Finance
Until now, the Islamic financial tools have
essentially been limited to classical modes developed
centuries ago. They were developed to meet the
needs of those societies. While they may serve as
useful guidelines for contemporary Islamic contracts,
there is no reason to be restricted only to those.
Financial markets are becoming more and more
sophisticated, and competitive. In order to exploit the
fast changing market environment and face
increasing competition, financial engineering and
innovation is imperative.
3
Scope for Financial Engineering in
Islamic Finance
Financial needs of both individuals and
businesses have changed. Engineers in modern
finance have designed several new ways such as
mortgages,
options,
derivatives,
hedging,
insurance pension plans, credit cards etc., to meet
those needs. We must examine what needs are
being fulfilled by these instruments. If the needs
are genuine (Islamically speaking), then we must
either adapt them for our purposes or invent
Islamic alternatives for them.
4
Scope for Financial Engineering in
Islamic Finance-Cont.
In the light of the principles of maslaha and
istihsan, a “needs approach” to financial
engineering is desirable, of course within the
known principles of Islamic finance. In this
regard, the example of bay‘ salam is very
important to remember. In general, it is not
allowed to sell anything, which is not in one’s
possession. But in case of salam, the Prophet
(pbuh) allowed such sale because of “need” of the
people, but laid down clear rules to protect the
interests of both parties.
5
Scope for Financial Engineering in
Islamic Finance-Cont.
The process of adaptation is well recognized in
Islamic fiqh and has never stopped. However, its
speed needs to be greatly enhanced. Classical
contracts have been modified in a number of cases to
meet current needs. One potent example is the
initiation of Islamic banking on the basis of almudarib udarib principle, which provides that a
mudarib (agent) may himself appoint another agent
to actually run the business. Another is the practice
of murabahah, through which the bank buys
merchandize upon the promise of another party to
purchase it from the bank at a higher price.
6
Scope for Financial Engineering in
Islamic Finance-Cont.
The principle of al-mudarib udarib essentially
allows for sub-contracting. If the principle is
acceptable, there is no reason to restrict it only to
mudarabah. Contracts can also be designed on the
basis of other principles, like al-muajjar uajjir, al
mustasna’ yastasna’, etc. In other words, the original
contractee may arrange to fulfil the obligations under
the contract through third parties. That the principle
is acceptable from an Islamic point of view is not
questionable.
7
Scope for Financial Engineering in
Islamic Finance-Cont.
While it is possible to modify classical contracts
to suit modern conditions, a much broader scope
for financial engineering exists in developing new
contracts. These contracts could be hybrids of old
contracts or may be entirely new. The scope for
financial engineering, and for that matter for
innovations in other fields, is quite wide. It is
important that the task is given over to those
experts who know the needs and niceties of the
trade.
8
Two kinds of Ahkam
Ibadat and Muamalat
The general principal in case of ibadat is that
nothing is that an act is ibadah only when
permitted by God.
9
The Doctrine of Original Permissibility
In case of muamalat, the general principal is
that of ibaha, i.e. everything is permitted
unless clearly prohibited by God. We call this
the Doctrine of Original Permissibility.
For prohibitions, Shariah provides general
guidelines to be observed. The interpretation
of these guidelines in every age is done
through the process of ijtehad.
10
Guidance From Quran on
Business Dealings:
•
‫يا أيها الذين آمنوا التأكلوا أموالكم بينكم بالباطل إال أن تكون تجارة عن‬
.‫تراض منكم‬
(.29 ‫ اآلية‬،‫– )سورة النساء‬
• “O Ye who believe! Eat not up your property
among yourselves unduly. Let it be trade
amongst you by mutual agreement”.
• This verse is perhaps the most important
verse of Quran on economic matters. It
tells us both the do’s and the don’ts in business
dealings.
• First the don’ts.
11
What is Prohibited in Business
Relations
 The verse rules out ALL illegal ways of wealth
creation. “Batil” encompasses any way of
acquiring wealth that violates the rights of:
 (a) God
 (b) Contracting Parties and
 (c) Third Parties
12
Prohibitions-I
 First and foremost those ways of wealth creation
are ruled out that are declared “illegal” by the
Supreme Law Giver. Examples of these are riba,
gharar, qimar.
13
Prohibitions-II
 The scope of the verse also includes all those
activities, which are declared “illegal” by the state
and its various echelons. Examples of these are
bribery, smuggling, money laundering.
14
Prohibitions-III
• Ways of creating wealth that violate the rights of
third parties are also prohibited. Examples of these
are creating pollution, obstructing common
passage ways and other negative externalities.
Zoning regulations by municipalities are covered
here
15
Kinds of Contracts
• Islamic contracts can be broadly classified
into two categories:
• Charity (Tabarruat) and
• Exchange (Muawadat).
• In this lecture our interest is in the latter.
16
Guidelines for Financial
Contract Design
• Freedom in determining the conditions of a
contract within Shariah rules.
• Prohibition of taking others’ property without
compensation
• Conscious Agreement within Shariah limits
• Mutual Benefit (Value Equivalence)
• Justice and Fairness (Elimination of Exploitative
Clauses)
• Provision of Maximum Possible Information
• Honouring the Spirit of Contract
17
What is Allowed in Business
Contracts
The Golden Principle of Free Choice
•‫المسلمون عند شروطهم إال شرطا حلل حراما أو حرم حالال‬
•“Muslims are free to determine the conditions of their contracts
unless they make something forbidden as permissible or
something permissible as forbidden”
In Islamic theory of contracts, parties are free to agree on any
terms as long as known Islamic rules and principles are not
violated.
18
Financial Contracts: Special
Conditions to be Observed
Prohibition of Riba
Prohibition of Gharar
Prohibition of Gambling
19
Prohibition of Riba
• Riba literally means increase, addition,
expansion or growth.
• In the Shari’ah , however, the term riba refers
to anything (big or small), pecuniary or nonpecuniary, in excess of the principal in a loan
that must be paid by the borrower to the
lender along with the principal as a condition
of the loan or for an extension in its maturity.
• In this sense, Riba has the same meaning and
import as the contemporary concept of
interest in accordance with the consensus of
all the fuqaha (jurists).
20
Prohibition of Gharar
• Gharar refers to act and conditions in
contracts, the full implications of which
are not clearly known to the parties.
• In economic parlance it is very close to
“Asymmetric Information.”
• It has two kinds: gharar yaseer (trivial)
and gharar fahish (substantial).
• The first kind is tolerated since this may
be
unavoidable
without
causing
considerable damage to one of the
parties.
21
Prohibition of Gambling
(Maysar)
‫ يا أيها الذين آمنوا إنما الخمر والميسر واألنصاب واأل زالم رجس من عمل‬
‫الشيطان فاجتنبوه لعلكم تفلحون‬
(.90‫ اآلية‬،‫(سورة المائدة‬
 O Ye who believe,
Intoxicants and Gambling,
(Dedication of ) stones, And (Dedication of) arrows, are
an abomination, of Satan’s handiwork: Eschew such
(abomination) , That ye may prosper.
 Gambling amounts to transfer of wealth without
any value added.
22
Some Relevant General Principles
of Shari’ah
•
•
•
No pain no gain (Al- Kharaju Bil-Daman)
Principle of Relief (Istahsan)
Doctrine of Necessity (Dharoorah)
23
The Four Cs of Islamic Financial
Engineering
• In addition to the Doctrine of Original
Permissibility and the Golden Principle of Free
Choice and the discussion of the few prohibitions,
we can summarize the guidelines for financial
engineering in what we call “Four Cs of Islamic
Financial Engineering”. These are:
• Consciousness
• Clarity
• Capability
• Commitment
24
Consciousness
That the parties should consciously and
willingly agree on the conditions of contract
without compulsion or duress. An implication
of this is that any agreement made in the state
of unconsciousness (like under the influence
of intoxicants or imposed by force ) is not
valid.
25
Clarity
That the parties are fully aware of all the
implications of the conditions laid down in a
contract. Any ambiguity (with the exception
of gharar yasir) will make the agreement
invalid. An implication is to minimize
asymmetric informatiom.
26
Capability
That the parties are reasonably certain that
they are capable of complying with all
conditions of the contract. An implication of
this is that sale of any goods (or services)
which are not owned and possessed by the
seller at the time of the contract is not valid.
27
Commitment
That the parties intend and are committed to
respect the terms of a contract both in letter
and spirit. An implication of this is that any
subterfuge to go around any Shariah condition
through linguistic or legal tricks is not
allowed.
28
Comments on Some Recent
Contracts
• Sukuk
• Tawarruq
29