Identifying and mitigating business risk in IF

The Quranic prohibition of riba has positioned al-bay (ie trade and commerce) as the alternative to the usurious system of financing which affected both household and mercantile sector in pre-Jahiliya Arab societies. While riba is profit derived from the extension of loans (qard) to borrowers, al-bay is a commercial endeavor undertaken by traders and merchants involving sale of goods.

Goods were initially purchased from suppliers and then sold in the marketplace for profits. The acquisition of profits in al-bay is subject to the movement of prices in the marketplace, which unlike the usurious loans will open the merchants to profits and losses. In this way, the initial capital injected by merchants to purchase the goods from suppliers is not protected from capital loss as it is exposed to business risk.

Trade and commerce (i.e. al-bay) also suggest that the basis of lawful profits is the holding of business risk by merchants as a consequence of taking full ownership of the goods intended for sale which is not the case for interest-bearing loans. This claim corresponds to the requirement of property, effort and liability in the acquisition of lawful profit (Mejelle 1877).

The holding of business risk in trading (al-bay), hence earmarks the justification of profits acquired from commerce. As Islamic banking operations are driven by the Shariah principles one of which is the application of al-bay in financial contracts, the taking of business risk by Islamic banks is a core principle. Operationally, it means that Islamic banks are required to hold the assets on its balance sheet before selling them to customers on credit basis. This is the nature of true sale credit financing where ownership of asset is first held by the selling party and shifted to the buyer upon the execution of the sale.

The ownership requirement is inescapable by default as dictated by the contract of sale based on the Hadith that “one must not sell something he does not own”. (Al-Bukhari) In this sense, the Islamic bank as the selling party must keep full ownership of the goods before making the credit sale, thus exposing the bank to market volatilities during the holding period. The legal maxim “al-ghorm bil ghuni” meaning that “profit is accompanied with risk” is derived from this true sale system as evidenced in the early Meccan trading culture. It is in direct contrast to the riba system where profits from loans (i.e. riba) were dictated by unfair terms and conditions.

While it is a bad business strategy to do true-sale credit financing using deposit funds as this will entail punitive capital charges, Islamic banks can do so using investment funds as stipulated by Bank Negara Malaysia (BNM) guideline of Investment Account 2014. The Islamic Financial Services Act 2013 (IFSA) distinguishes investment account from Islamic deposits, where investment account is defined by the application of Shariah contracts with non-principal guarantee feature for the purpose of investment. Exposures funded by Investment accounts under the pretext of unrestricted investment account (URIA) and restricted investment account (RIA), do not need capital cushioning, thus releasing Islamic banks from unwarranted capital stress.

What more could we ask from BNM who have done a great job to help facilitate inventions of new Islamic financial products funded by investment accounts. Identifying, measuring and mitigating business risk will be the new challenge to Islamic banks going forward.

By Prof. Saiful Azhar Rosly

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