Risk Sharing and Shared Prosperity in Islamic Finance

Abstract

This paper argues that risk sharing is an effective method of expanding participation of agents in economic growth and development and more effective sharing of fruits of prosperity than risk transfer that currently dominates financial systems. Kuala Lumpur Declaration of 2012, by a group of leading Sharī‘ah scholars and Muslim economists, considers risk sharing as the essence of Islamic finance, a litmus test of which is its ability to promote financial inclusion and asset-building capacity of the poor and thus better sharing of prosperity. The mobilisation of financial resources toward productive activities through risk sharing enables the Islamic financial system to actualize economic justice and social participation in an efficient manner. The asset-backed equity-financing nature of Islamic finance is conducive to financial system stability because returns, which can only be known ex post, and thus shared on the same basis, are not divorced from risk. Stability and equitable growth challenges are arguably difficult to undertake through debt-financing, which transfers the burden of losses from financiers to entrepreneurs even at microfinance levels, distorts economic incentives, increases systemic risk, and renders financial regulation more complex. The procyclicality of the conventional financial system leads to credit contraction during economic downturns, precisely when the need rather increases for real investment to stimulate economic output and reduce unemployment. Financial intermediaries tend rather to respond to changes in the riskiness of assets by adjusting balance sheets through credit contraction and various mechanisms of credit risk transfer. This study is an attempt to demonstrate that the risk-sharing modes of financing real investment in the public and private sector reduce the procyclicality of the financial system. The equity-financing of real investment is conducive to more efficient channels of savings towards development finance. The risk-sharing principle underlying Islamic finance reduces the economic incentives for credit risk transfers and speculative activities. By preventing risk from being entangled in complex debt-creating structures that characterize the incompleteness of contracts under conventional finance, this principle also redefines the role of financial markets and institutions in smoothing consumption and capital expenditure. It is the asset-backed nature of Islamic finance that allows for a participative securitization process that provides different segments of the society with fair opportunities to share economic prosperity. The allocation of risk commensurate to the idiosyncratic abilities to bear losses is arguably more conducive to a socially inclusive financial system. Systematic risk cannot be eliminated, but it is collective risk taking and individual risk aversion that promote more efficient mobilisation of resources, and more equitable sharing of economic risk and prosperity.