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Islamic Finance Essay

Islamic Finance Essay

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Allah Works in Mysterious Ways Especially in the World of Finance: An argument that social constructivism better explains the

challenges of accountability that Islamic finance poses international regulatory institutions better than neoliberalism

LO, Stephen Andrew Kai Tai POLI 344 A03 Dr. Bartholomew Paudyn August 12, 2010

Unlike conventional financial tools. Introduction i. 2007: 1-2). 2007: 38). as an amalgam between traditional Islamic ethics and modern bourgeois enterprise. 2005: 1-3). However. Khaf. Islamic finance. the reader will observe that this essay argues that social constructivism explains the absence of a harmonized regulatory regime of Islamic finance better than neoliberalism especially in the field of corporate accountability. Islamic finance is also a sector that is still relatively young in the financial world. 2007: 38). this begs the question: Why does social constructivism explain the existence of regulatory challenges in accountability of Islamic financial institutions to international institutions better than neoliberalism? With this question in mind. Modi.. i. Islamic finance is a sector of the financial industry that is theoretically supposed to conform to strict ethical standards imposed shari’a (Islamic religious) law and rulings. greater profit margins. and innovative financial engineering. 2005: 22. 2005: 2. which prohibit any financial transactions that are considered haram (not meeting shari’a standards) (Modi. with rapid growth rates (of 1015% annually in the 1990s and 2000s). the Islamic financial industry has not successfully achieved a state of financial harmonization (Modi. Allah Works in Mysterious Ways: Especially in the World of Finance With its origins in the late 1970s. Islamic financial institutions being able to honestly account for the operational procedures and investment decisions made on . has been one of the fastest growing sectors in the international financial industry for the past decade (Henry & Wilson. yet it remains poorly understood in both the Middle East and the West (Henry & Wilson.e.Lo 2 I. and the lack of harmonization and standardization in Islamic finance poses a major challenge to the proper regulation of the Islamic financial industry (Hassan & Lewis. 2007: 38).

and I. II.Lo 3 behalf of their investors. shari’a compliance. exposes the reader to the regulatory structure of Islamic financial governance. Body. and shows that the governance of Islamic finance is deeply rooted in religious and cultural factors. Structure of the Argument. Introduction is divided into two subsections: I. this subsection will show the basic structure of this essay. ii. II. is an outline of the how this essay presents the argument: Why does social constructivism explain the existence of regulatory challenges in accountability of Islamic financial institutions to international institutions better than neoliberalism? II. Subsection I. Understanding the Governance of Islamic Financial Institutions and II. i. ii. ii. introduces the reader to the basic premises of the theories of neoliberalism and social constructivism.i. Structure of the Argument Before defending the position that this essay argues for. I. ii. Body is divided into three subsections: II. and III. introduces the significance of Islamic finance to international political economy by giving the reader a general view of Islamic finance in the world. i. Introduction. ii. II. Allah Works in Mysterious Ways: Especially in the World of Finance. The Neoliberal Failure of Regulating Islamic Financial Institutions. II. I. . Conclusion: Accommodating Differences in International Financial Regulation Rather than Coloring the World with One Monochromatic Brush. The Theories of Neoliberalism and Social Constructivism. and that regulating the accountability of Islamic financial institutions proves challenging especially in fields of risk mitigation. i. iii. governance power of investors and transparency. II. This essay is structured into three sections: I.

Body i. the International Convergence of Capital Measurement and Capital Standards: a Revised Framework (Basel II). 118. Social constructivism is a theory that has a different ontological approach vis-àvis neoliberalism. and that social constructivism better explains these phenomena. and is premised on the notion that phenomena. II. III. 2007: 124). especially in accountability. This section also gives recommendations to further integrate and harmonize Islamic finance in international political economy in a manner where investors are better protected. The Theories of Neoliberalism and Social Constructivism Neoliberalism is an analytical theory premised on rationality and contracting to study the centrality of institutions and organizations in international politics. Conclusion will conclude the essay by exposing the failure of neoliberalism in explaining the regulatory challenge that Islamic finance poses the world of finance.. 2007: 111). This perspective posits that international institutions monitor. escaped regulation and monitoring by international regulatory agencies such as the Islamic Financial Services Board. and serve as forums where different parties can communicate problems that arise in coordination and be informed of preferences and constraints that they face (Martin. etc. which are socially . provide assurances that agreements will be met. by and large. Neoliberal analysts tend to use a principal-agent framework to study how international organizations and institutions function deliver their mandates (Martin. while shari’a law is observed in Islamic finance. and their role in resolving collective action problems (Martin. provides further evidence to show that Islamic financial institutions have.Lo 4 iii. 2007: 110. the International Monetary Fund. the Basel Committee for Banking Supervision (BCBS). 124).

2010: 114-116. Understanding the Governance of Islamic Financial Institutions Islamic finance exists as an alternative to conventional banking by adhering to norms that are acceptable under Islamic shari’a law (Hassan & Lewis. The bedrock of Islamic financial mediation is the mudarabah . Islamic finance has a different set of financial tools from their conventional western-style counterparts. so that operations would help create a fairer and more equitable society (Hassan & Lewis. Islamic finance. 2007: 168). interest and usury). maysir (gambling and speculation). therefore. 1999: 371). Wendt. 2007: 2-3. i. Fierke: 2007: 168. and requires that Islamic financial institutions benefit society through the collection of zakat (almsgiving). when practiced in a hallal (in accordance to shari’a law) manner. Algaoud & Lewis. which is overseen by a special religious supervisory board. and gharar (unreasonable uncertainty). occur across context rather than a single objective reality (Fierke. 114-116). 2007: 2). 2007: 38-47). When using social constructivism to analyze issues in international political economy. but instead operates on a regime of profit and loss sharing. where investment accounts offer money lending services and returns that are competitive with those of conventional finance (Algaoud & Lewis: 47). Social constructivism puts an emphasis on the importance of holistic ideational factors in international phenomena such as norms. epistemic communities and the influence of the norms and values that they project in governance are central (Cohn. Islamic finance. strictly prohibits riba (excess. rules and language rather than on rather constant individualist-materialist factors such as monetary reserves and balance sheets (Cohn. does not use interest at predetermined rates.e. ii. 2010.Lo 5 constructed.

With this alternative financial model. Islamic finance is based on the adherence to shari’a law. 2007: 22). 2007: 22). and with the support of the World Bank. Islamic Financial Services Board. Islamic finance has. etc. there is a tendency for investors. which have few institutional infrastructures to such schemes (van Greuning & Iqbal. and as a result. to be conservative in the profit sharing and loss bearing schemes. 2007: 16-17). Under the leadership of the Islamic Development Bank. there has been a push towards a strengthening of the regulatory structure of Islamic financial institutions through greater regulatory harmonization (Iqbal. at present. IMF and the Basel Committee. iii. However. 2007: 22-23). 2007: 382). However. Investors would deposit their money into their investment account for the Islamic financial institution to manage by lending money to other enterprises that will use the money in asset-backed financial claims or profit sharing and loss bearing schemes (van Greuning & Iqbal. these regulatory reforms face the unsavory possibilities of having regulatory agencies duplicate regulatory competences and being whitewashed in order to be regulated with conventional financial institutions (Iqbal. Islamic financial institutions.Lo 6 (investment) contract (van Greuning & Iqbal. its plethora of regulatory structures such as the Islamic Development Bank Group. This contractual institution in Islamic financial institutions creates a situation where depositors/investors are acting as if they were shareholders of securities (van Greuning & Iqbal. 2007: 382). Accounting and Auditing Organization for Islamic Financial Institutions. and . The Neoliberal Failure of Regulating Islamic Financial Institutions Another challenge that regulators of Islamic finance also face problems of corporate accountability.

2007b: 320). Holders of investment accounts with Islamic financial firms have far less governing powers than investment accounts of conventional financial firms. and are usually treated not too differently from conventional commercial banks. investors might not have enough information to make informed investment plans when putting money into their Islamic financial contracts and to be ensured that the Islamic financial institution is sound and operating in an honest and disciplined manner within the confines of the market (Archer & Karim. 2007: 203). 2007b: . and as a result. Islamic financial institutions are normally regulated by national central banks. while most Islamic financial institutions tend to have a convoluted conception of investor and depositor. There is also a lack of transparency in how accounts are managed. 2007b: 328-329). 2007b: 333). and requires a Shari’a Supervisory Board to ensure compliance with shari’a practices by issuing rulings and fatwa. since penalty clauses are haram (Bahmbra. even though their business models are rather different (Archer & Karim. where profit is involved (Archer & Karim.Lo 7 has cultural particularities that do not exist in conventional banking (Bahmbra. such as defaulting debtors might not be as easily resolved as in conventional banking due to shari’a law. This approach is problematic because most central banks tend to protect depositors more than investors. since the investor has no governance over how the money is invested. also tarnishes the confidence of investors of the Islamic financial institution or even towards the industry itself. Risks that are identified in Islamic finance. unless he or she terminates the mudarabah contract that he or she has with the Islamic financial institution (Archer & Karim. On another note. Non-compliance with shari’a. which need to be circulated and implemented by the firm (Bahmbra. 2007: 205). 2007: 203-204).

Basel II is divided into three “Pillars”. legal risks especially in instances that are precedent setting or require litigation (Nakajima & Rider. Pillar 2 addresses the supervisory review process from the perspective of the responsibility of the supervisor to promote the stability of the banking system. which was introduced by the BCBS to better mitigate risks.Lo 8 333). 2007: 342-343. 350. Pillar 1 provides new solutions to credit risk from the operational risks outlined in the 1988 Capital Accord (Basel I). set up common guidelines for supervisory review and the importance of dialogue between supervisors and banks. 357). It is very likely that Islamic financial institutions would require a different regulatory approach from what is presently practiced that both treats Islamic financial institutions both as banks and securities (Archer & Karim. 2007b: 333-334). There remain major challenges in ensuring that Islamic financial institutions do not take excessive risks that could potentially destabilize the Islamic financial industry under Pillar 2 such as terrorism. Pillar 3 outlines the minimum number of public reporting standards on risk and risk management so that market participants can be aware of a bank’s risk profile and the adequacy of its capital relation to the bank’s risk profile. Another challenge that Islamic financial institutions provide the international regulatory regime is that Islamic financial institutions do not fall neatly under Basel II. thereby involving the market in the capital adequacy regime (Archer & Karim. ensure financial stability. increase market confidence and provide investors with reliable information about the health of financial institutions. Under Pillar 3. 2007a: 2). regulators face challenges in ensuring transparency via information disclosure that must be credible so that investors could make informed investment choices and ensure that Islamic financial companies adhere to the regulations to which they are subject to so that .

which are the norms that devout Muslims adhere to in their daily dealings in the world. 2007: 377-378). as an industry. especially when the regulatory structure in place is not strong enough to properly regulate the industry. and impose sanctions on the governing bodies of Islamic financial institutions that do not follow the regulations (Abdullah. although quickly growing does not rely on the financial tools available to conventional finance. Norms and best practices will need to be introduced to ensure that Islamic financial institutions function in an responsible manner without taking excessive financial risks especially when such norms and best practices are not yet in place. From these observations. norms and values are far more important than profits that are made from a purely rational-choice perspective. thanks to the norms that religious scholars and Islamic financial traders have decided to adhere to in the industry. insufficient confidence. Conclusion After reviewing the dynamics in the regulation of the Islamic financial institutions.Lo 9 investors and regulators can name and shame. which is premised on rational choice and the role of institutions acting as a forum where problems of coordination. is firmly rooted in the traditions and ethical framework of shari’a law and ruling. it is apparent that neoliberalism. though full of regulatory challenges in regards to accountability. especially when Islamic financial institutions have an aversion to practices that are normally considered acceptable and perfectly legal in conventional finance. communications of preferences and . These ideational factors are of utmost importance in the institutionalization of norms and practices in the relatively new industry of Islamic finance. regulation. This shows that in Islamic finance. especially those that bare interest. III. Islamic finance. it is very clear that Islamic finance.

thus providing investors with sound information. profit-maximization. an ideational theory. a substantive theory based on rational-choice. On afterthought. especially when Islamic financial institutions are not just-for-profit institutions that have a duty to give back to society.Lo 10 restraints are resolved. This essay strongly defends that social constructivism. Social constructivism.e. These proposed changes in financial regulation can pave the way to a global financial system that operates more efficiently while allowing for greater diversity and choice for investors who are conscious of ethics and norms. these norms and regulations cannot be implemented without expert advice formed in the epistemic communities of mullahs. If Islamic finance is to be a force in international political economy that will be of great significance. better explains the changes that the Islamic financial industry is going through in terms of corporate accountability and regulation than neoliberalism. greater harmonization and standardization and a different regulatory approach vis-à-vis conventional banking. financiers and central bankers. . although the fast-growing industry of Islamic finance requires more effective regulation. and be able to manage risks more effectively. i. fails to explain the peculiarities of the accountability of the Islamic financial industry which challenges the transnational neoliberal regulatory regime. on the other hand. international organizations and other supervisory bodies need to modify their regulatory practices so that the Islamic financial industry would be properly monitored and become more transparent. as well as the still-under-construction regulatory regimes that still have immense regulatory gaps that still need to be closed but not duplicated and best practices that still have yet to be determined.. takes into account the cultural and ethical tendencies that helped construct the Islamic financial industry.

Lo 11 After observing these points. other questions that the argument of this essay can lead to are: Do neoliberal institutions stifle innovations that exist in the free market because of bureaucratic dogma and inefficiency? Does financial reform and harmonization require an ideational shift? .

Specific Corporate Governance Issues in Islamic Banks In S. Singapore: John Wiley & Sons (Asia) Pte Ltd. (2007). A.). In M. Islamic Finance: The Regulatory Challenge (pp. M. Northampton. M. (2007). . A. 38-48). Archer and R.). Supervisory Implications of Islamic Finance in the Current Regulatory Environment. 1-14). The Politics of Islamic Finance (pp. Inc. Karachi. In M. H. K.). M. Northampton. & Karim. New York: Oxford University Press van Greuning. Islamic banking: an introduction and overview. A. H. In S. 198-212). A. Global Political Economy: Theory and Practice (5th ed. Hassan and M. A. Algaoud. (2007). (2007a). K. Lewis (Eds. & Iqbal. Singapore: John Wiley & Sons (Asia) Pte Ltd. Islamic Finance. Inc. A. L. In S. M. Karim (Eds. T. M. & Wilson. 1-17).).). & Lewis. A. A. Cohn. (2005). New York. Archer. Singapore: John Wiley & Sons (Asia) Pte Ltd. Supervision of Islamic Banks and Basel II: The Regulatory Challenge. & Lewis. Islamic Finance: The Regulatory Challenge (pp. Inc. K. R. (2010). M. Fierke. International Relations Theories: Discipline and Diversity (pp. Global Politics. Hassan and M. Pakistan: Oxford University Press. Henry.). 1-7). NY: Pearson Education. Z. Handbook of Islamic Banking (pp. Islamic critique of conventional financing.Lo 12 References Abdullah. K. Lewis (Eds. Banking and the Risk Environment. Transparency and Market Discipline. H. K. K. (2007). Islamic Finance: The Regulatory Challenge (pp. M. Singapore: John Wiley & Sons (Asia) Pte Ltd Hassan. Wilson (Eds. Archer and R. In S. (2007). Constructivism. 366-378). D.). Archer and R. Karim (Eds. In C. Handbook of Islamic Banking (pp. T. K. Archer and R. MA: Edward Elgar Publishing. A. In Dunne. Archer and R. Karim (Eds. Islamic Finance: The Regulatory Challenge (pp. — (2007b). In S. 1139). Bhambra. K. 310-341). Henry and R. A. & Smith S. A. S. (Eds. Singapore: John Wiley & Sons (Asia) Pte Ltd.). MA: Edward Elgar Publishing. 166-184). R. (2007). Islamic Finance: The Regulatory Challenge (pp. Karim (Eds. and Islamist Politics Before and After 11 September 2001.). .). Kurki. Karim (Eds. C. M.

M. I. 17-36). Lewis (Eds. Neoliberalism. Henry and R. Pakistan: Oxford University Press. T. Warde. (2005). A Social Theory of International Politics. In S. Hassan and M. A. 38-41. In Dunne. A. (2007). K. (Eds. Northampton. Kurki. Global Politics. In C. 29(1). C. M. Islamic Banks: The Rise of a New Power Alliance of Wealth and Shari’a Scholarship. Corporate Governance and Supervision: Basel Pillar 2. M. Harvard International Review. K. 37-62). (2007).Lo 13 Iqbal. Henry and R. In M.). Nakajima.). Writing the rules: the need for standardized regulation of Islamic finance. 342-365). Karim (Eds. (2005).). In C.). A. Wilson (Eds. Singapore: John Wiley & Sons (Asia) Pte Ltd. Wendt. Martin. M. A. Handbook of Islamic Banking (pp. Archer and R. New York. The Politics of Islamic Finance (pp. International Relations Theories: Discipline and Diversity (pp. International Islamic financial institutions. 109-126). L. The Politics of Islamic Finance (pp. L. Karachi. (1999). Karachi. Kahf. 361-383). Wilson (Eds. and Islamist Politics Before and After 11 September 2001. Islamic Finance. M. (2007). V. . & Smith S. K. (2007). New York: Oxford University Press Modi. Pakistan: Oxford University Press. MA: Edward Elgar Publishing. NY: Cambridge University Press. Inc. & Rider B. Islamic Finance: The Regulatory Challenge (pp.).

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