Intermediate Islamic Finance. Mirakhor Abbas

the debate regarding the scope of derivatives and financial engineering in Islamic finance, and the importance of regulatory measures to promote derivatives transactions for bona fide hedging that are permissible and restrict speculative strategies that are not. The principle of risk sharing may indeed be associated with a corollary of risk hedging in Islamic finance.

      Chapter 7 provides an analysis of financing modes based on risk sharing and their implications for ownership transfer. It explains the conceptual differences between non-risk-sharing contracts such as conventional loans, and participatory models, such as sale with deferred payments (albaý biththaman al-ājil), diminishing partnership (mushārakah mutanāqisah), and diminishing balance partnership. The focus is made on the structure and dynamics of outstanding balances. This chapter explains the trade-off between the preference for fixed annuities payments and the pursuit of faster ownership transfer. The hybrid financing models based on murābahah and mushārakah principles have the potential of solving the issue of rate compounding and promoting the financier's right to legitimate profits, which are negotiable in a competitive economy. They may also be helpful in optimizing the customer's ownership transfer rates and meeting individual preferences for constant or variable installments. Risk sharing in Islamic finance can be promoted through the concept of completeness of contracts, where partnership agreements allow for the revision of contractual terms contingent on the realization of particular states of nature. Thus, Chapter 7 describes the main features of financing models based on risk sharing and explores the linkage between the financial sector and the real economy insofar as the relation between payment ratios and ownership transfer rates is concerned.

      Chapter 8 constitutes the last chapter in the analytical part of this book, and it deals with securitization and structured finance. It starts with an explanation about the transfer of credit risk off-balance sheet through credit default swaps, allowing banks to circumvent regulatory strictures about capital adequacy ratios and increase liquidity. It describes also the mechanics of securitization, which in the case of loan portfolios enables credit expansion and increases leverage in the financial system. It is shown that the pass-through form of securitization where certificate holders have pro rata property rights over the securitized Sharīa'h-compliant assets may provide value to society by offering new channels for risk diversification and risk sharing. It is structured finance that alters pro rata claims on future cashflows and tilts the risk exposure of investors to provide credit enhancement for senior tranches at the detriment of equity and mezzanine tranches. The analysis can shed light on whether the capital structures of special-purpose-vehicles in sukuk issuances are the result of debt-creating structures rather than equity financing. The risks to financial stability derive from the complexity of structured finance and the ratings process, and the imprecision in evaluating the underlying risks and default correlations.

      This chapter also explores ways in which risk transfer can be also reflected in complex double-wa'ad structures for total return swaps and for short selling. These complex trading structures are better understood within the classical analytical framework of options contracts described in Chapter 6. Since the role of double-wa'ad structures in total-return-swaps and short-selling strategies can only be effective as binding promises not just moral obligations, some clarity can thus be brought to the debate about the essence of wa'ad. Thus, securitization and structured finance, as well as wa'ad structures for total-return-swaps and short-selling, represent various strategies for risk transfer off-balance-sheet, or exposure to the underlying asset without ownership.

      Chapter 9 examines issues related to financial stability. The focus on the stability of the financial system is justified in light of the previous discussion about the epistemology of finance in Chapter 1 and about the potential for structured finance to increase the on- and off-balance-sheet leverage and the risk-taking capacity of the shadow banking system in Chapter 8. The emphasis in Chapter 9 is made first on the procyclicality of the financial system, which reflects its propensity to amplify shocks to the real economy and exacerbate business cycle fluctuations. The focus is then made on the nature of financial crises, systemic risk, and the inherent instability of debt-driven financial systems. The discussion is then centered on the stability of the two-tier financial system under Islamic finance based on the full-reserve money system and the investment banking system.

      Finally, Chapter 10 considers financial regulation in light of the previous discussion in Chapter 9 about the properties of the conventional and Islamic financial systems. It addresses first the economics of regulation and the complexity of financial regulation. The fragility of the financial system due to the fragility of banking arrangements has implications for financial regulation. The complexity of the regulatory framework for the conventional financial system is thus reflective of the complex nature of debt and debt-like obligations. Given the prevalence of risk transfer arrangements, prudential regulation is affected by moral hazards and negative externalities. This chapter also describes the main features of the regulatory environment under Islamic finance. The equity-based financial system is conducive to greater financial integration and financial stability, as it promotes incentives for all economic agents to participate in decision making and therefore reduces moral hazards. The focus thus is not made on the democratizing and humanizing of credit but of risk-bearing and risk-sharing mechanisms that have the potential to lighten the burden of financial regulation.

      Given the critical and analytical orientation, this work, unlike standard textbooks, leaves other important areas in Islamic finance such as jurisprudential and legal perspectives rather untouched. This book is not intended, however, to serve only the needs of the academic community for teaching materials. It can also serve as a guide to the theory and practice of Islamic finance for practitioners, including finance professionals, regulators, and policymakers. This book is indeed written for readers with either applied or theoretical interest in Islamic finance. Readers with interests in applied Islamic finance may find Chapters 1, 2, 6, 7, 8 and 10 more appealing. Those with purely theoretical interests may focus on Chapters 1, 2, 3, 4, 5, and 9. It is clear that Chapters 1 and 2 would appeal to both. At several stages in the analytical presentation, as well as at the end of each chapter, there is a critical discussion of the possible interpretations of assumptions and results from the perspective of Islamic finance. It is toward these sections that readers who are not familiar with analytical methods may seek guidance and further understanding about the relationship between Islamic finance and conventional finance.

      The analytical parts of the book may be technically demanding, but they can be avoided by readers who are ready to accept the economic implications of these results. Analytics is no substitute for intellectual debate about economic and financial matters, but it can, as a convenient tool, bring some clarity to the issues at hand. This book is a humble attempt to explain Islamic finance from an analytical perspective, and the mathematical accuracy of the results, economic interpretations, and practical implications are subject to debate and further development. This is not an attempt at explaining conventional finance from an Islamic perspective, but at elucidating the essence of Islamic finance based on the placement of risk sharing at the crossroads between