Mutuality as an antidote to rent-seeking Shariah arbitrage in Islamic finance

Islamic finance is a prohibitions-driven industry, which aims primarily to circumvent the canonical Islamic prohibitions of riba and gharar. The concepts of riba and gharar may best be understood as unbundled sales of credit and risk, respectively. An obvious solution is to adopt mutual structures for financial intermediaries of credit (e.g. banks) and risk (e.g. insurance companies), as early experiments in Islamic finance had apparently done. However, growth in Islamic finance over the past three decades has been led by rent-seeking Shari`a arbitrageurs, whose efforts continue to be focused on synthesizing contemporary financial products and services from classical nominate contracts, without regard to corporate structure of financial institutions. In this paper, I argue that mutuality should be given back its central role in our discourse on Islamic finance. In particular, I argue that mutuality in intermediation of credit and risk can assist significantly in implementing the substance of Shari`a as well as its forms, including the financial empowerment of Islamic financial customers (be they Muslims or otherwise) to face the challenging domination of Islamic finance by international financial behemoths. Introduction: Absence of Mutuality in Islamic Banking and Insurance The theory of Islamic banking is often attributed to Uzair (1955), and later literature that focused on a mutual-fund style double-tiered silent partnership model, c.f. Siddiqi (1983). The contemporary Islamic banking model began with the establishment of Dubai Islamic Bank (1975), followed by Kuwait Finance House, Faisal Islamic Banks in Egypt and Sudan, and Al-Baraka banks, most financed by windfall wealth following the dramatic rise in oil prices in 1973. In due course, the industry utilized synthetic loan structures based on credit sales and leasing, pioneered theoretically by Humoud (1976), to replicate much of the asset-structure of conventional banks. Recent innovations have allowed governments and corporations to issue sale and lease-based debt instruments, known by the Arabic name sukuk (=certificates, or bonds), thus allowing Islamic banks to replicate all asset classes held by conventional banks. However, the liabilities structures of Islamic banks have remained committed to the theoretical model of two-tiered silent partnership, developed by Islamic economists and implemented in the 1963 Islamic banking experiment in the village of Mit Ghamr, Egypt. Under that arrangement, the bank was capitalized by external shareholders, and accepted three types of deposits: demand deposits on which no interest was paid, investment deposits on which a profitshare was paid or to which loss-shares were charged, and zakah deposits. Investment accounts based on profit and loss sharing continue to be the main distinctive feature of Islamic banks, to which much of the work of AAOIFI (Accounting and Auditing Organization for Islamic Financial Institutions, in Bahrain) and IFSB (Islamic Financial Services Board) is devoted. As of the writing of this article, IFSB has not yet issued its discussion paper on corporate governance for Islamic banks, which will address the fundamental agency problem facing those investment account holders. Of particular concern in this context is the fact that Islamic bank managers answer to shareholders, whose risk preferences (associated with equity investment) are typically quite different from those of investment account depositors (conventionally associated with debt investments). The problem is exacerbated by investment account holders’ lack of control over bank decisions, which exposes them to substantial moral hazard compared to bank shareholders. Investment account holders are also disadvantaged relative to conventional depositors who are deemed creditors of the bank, and thus have first claims to its assets in case of bankruptcy. A natural solution to this problem is for Islamic banks to adopt a mutual corporate structure. As we shall see in future sections, the mutual corporate form does not eliminate moral hazard entirely, since shareholder/depositors are typically too small individually to control bank operation. Indeed, literature on mutual banks often identifies each shareholder’s ability to withdraw his deposit from the bank as the only means of punishing its managers – a prospect called “displaced commercial risk” in the literature on Islamic banking. However, by eliminating the separate group of profit-oriented shareholders from the formula, or putting them on par with investment account holders in the corporate structure, managers’ incentive for excessive risk taking is largely eliminated, resulting in lower risk-taking that reflects depositors’ preferences. Interestingly, historical studies of Islamic banking prior and leading to the Mit Ghamr experiment in Egypt points to the strong influence of European mutual banking institutions and cooperatives. This influence applied equally to early 1950s banking experiments in Pakistan, as well as the 1960s Malaysian Tabung Haji, which eventually gave rise to the fast growing Malaysian Islamic banking sector. Dr. Ahmed Al-Najjar’s initiative in Mit Ghamr appears itself to have been equally influenced by the social and economic thought of the Muslim Brotherhood, and the mutual banking institutions that Dr. Al-Najjar witnessed in West Germany during his study there, c.f. Warde (2000, p.73 and the references therein). The later GCC-based pioneers of Islamic banking in Dubai, Kuwait and Saudi Arabia capitalized the first group of Islamic banks in the mid 1970s, and later lamented the modes of operation adopted by those banks, which mimicked conventional banking practices. Many today criticize Islamic banks for failing to deliver economic and social development to Muslim populations that remain among the poorest and least educated in the world. Indeed, Dr. Al-Najjar, Sh. Saleh Kamel, and most of the early pioneers of Islamic banking expressed their displeasure with the industry’s modes of operation on the assets-side, and predicted that foreign banks would soon be able to capture significant market share in an Islamic banking industry built on synthesizing loans and bonds from sales and leases, c.f. Saeed (1997, pp. 119-128) and the references therein. In later sections, I shall argue that mutuality in Islamic banking can in-fact bring to the industry large numbers of depositor/investors as well as managers who are committed to Islamic ideals of social and economic development, as opposed to profit and fee oriented Shari`a arbitrageurs. A by-product of identification of Islamic banking with mutualization would be to give indigenous Islamic banks a much-needed comparative advantage vis-à-vis international financial behemoths that have been able to attract the most respected Shari`a advisors and law firms, thus capturing fast-increasing market shares in today’s Islamic finance industry that is built on rent-seeking Shari`a arbitrage. The absence of mutuality is even more surprising in the Islamic insurance industry, known generally by its Arabic name takaful (= mutual guaranty). It is interesting that even companies that use the term takaful ta`awuni (= cooperative mutual guaranty or insurance) have not adopted mutuality structures. This is particularly astonishing given the classical ruling 9/2 of the Fiqh Academy of the Organization of Islamic Conference (OIC), which distinguished commercial insurance from what it called “cooperative insurance ... built on the principles of voluntary contribution (tabarru`) and mutual cooperation”. In fact, the contemporary Islamic insurance industry has adopted a superficial mutuality notion in its name (takaful), but not in substance. Thus, most Islamic insurance providers are structured with stockholder rather than policyholder ownership. Insurance claims are paid by shareholders through the takaful provider on the basis of tabarru` (voluntary contribution, as opposed to contractual obligation). This model based on voluntary contribution, replacing commutative contractual obligations with legally binding unilateral promises, raises a host of legal and juristic problems that have not yet been resolved fully. While insurance providers are typically characterized as investment agents of the stockholders, Bank Al-Jazira in Saudi Arabia has pioneered a characterization of insurance provider as pure agent (wakil, rather than mudarib). This can be a step towards eventual mutualization, where the insurance provider can act as a pure agent for shareholders who are themselves the policyholders. This would satisfy the most widely accepted means of eliminating gharar from insurance, by negating the commutative financial nature of the transaction through mutuality. However, there seems to be precious little initiative for mutualization in the Islamic insurance industry. In the remainder of this paper, I shall briefly review the historical roots of mutualization in banking and insurance. In this regard, the goal of obtaining credit and insurance at fair prices seems to have been the primary driving force behind the mutuality movement in Europe and the U.S. This objective can also be seen as the foundation of prohibition of riba and gharar, which allow financiers to profit from the sale of credit and risk. Contemporary Islamic finance has focused on the elimination of unbundled sales of credit and risk by bundling credit in sales or leases, and re-characterization of the sale of risk in terms of voluntary contributions. In other words, it has focused on contract forms, without changing the substance of the underlying economic transactions, which remain essentially sales of credit and risk. While such contractual re-characterizations of the contract forms are likely to remain fundamental to Islamic finance for the foreseeable future, substantive contractual modifications that minimize the profit motive through mutualization can help the Islamic f