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Financial Engineering and Evaluation of New Instruments. Dr. Munawar Iqbal Chief of Research (Islamic Banking and Finance) IRTI, Islamic Development Bank DLC Lecture November, 2004. Definition of Financial Engineering.
Dr. Munawar Iqbal
Chief of Research (Islamic Banking and Finance)
IRTI, Islamic Development Bank
Financial engineering can be defined as ‘the design, development, and the implementation of innovative financial instruments and processes, and the formulation of creative solutions to problems in finance’.
Until now, the Islamic financial tools have essentially been limited to classical modes developed centuries ago. They were developed to meet the needs of those societies. While they may serve as useful guidelines for contemporary Islamic contracts, there is no reason to be restricted only to those. Financial markets are becoming more and more sophisticated, and competitive. In order to exploit the fast changing market environment and face increasing competition, financial engineering and innovation is imperative.
Financial needs of both individuals and businesses have changed. Engineers in modern finance have designed several new ways such as mortgages, options, derivatives, hedging, insurance pension plans, credit cards etc., to meet those needs. We must examine what needs are being fulfilled by these instruments. If the needs are genuine (Islamically speaking), then we must either adapt them for our purposes or invent Islamic alternatives for them.
In the light of the principles of maslaha and istihsan, a “needs approach” to financial engineering is desirable, of course within the known principles of Islamic finance. In this regard, the example of bay‘salam is very important to remember. In general, it is not allowed to sell anything, which is not in one’s possession. But in case of salam, the Prophet (pbuh) allowed such sale because of “need” of the people, but laid down clear rules to protect the interests of both parties.
The process of adaptation is well recognized in Islamic fiqh and has never stopped. However, its speed needs to be greatly enhanced. Classical contracts have been modified in a number of cases to meet current needs. One potent example is the initiation of Islamic banking on the basis of al-mudaribudarib principle, which provides that a mudarib (agent) may himself appoint another agent to actually run the business. Another is the practice of murabahah, through which the bank buys merchandize upon the promise of another party to purchase it from the bank at a higher price.
The principle of al-mudaribudarib essentially allows for sub-contracting. If the principle is acceptable, there is no reason to restrict it only to mudarabah. Contracts can also be designed on the basis of other principles, like al-muajjar uajjir, al mustasna’ yastasna’, etc. In other words, the original contractee may arrange to fulfil the obligations under the contract through third parties. That the principle is acceptable from an Islamic point of view is not questionable.
While it is possible to modify classical contracts to suit modern conditions, a much broader scope for financial engineering exists in developing new contracts. These contracts could be hybrids of old contracts or may be entirely new. The scope for financial engineering, and for that matter for innovations in other fields, is quite wide. It is important that the task is given over to those experts who know the needs and niceties of the trade.
Ibadat and Muamalat
The general principal in case of ibadat is that nothing is that an act is ibadah only when permitted by God.
In case of muamalat, the general principal is that of ibaha, i.e. everything is permitted unless clearly prohibited by God. We call this the Doctrine of Original Permissibility.
For prohibitions, Shariah provides general guidelines to be observed. The interpretation of these guidelines in every age is done through the process of ijtehad.
The Golden Principle of Free Choice
In Islamic theory of contracts, parties are free to agree on any terms as long as known Islamic rules and principles are not violated.
That the parties should consciously and willingly agree on the conditions of contract without compulsion or duress. An implication of this is that any agreement made in the state of unconsciousness (like under the influence of intoxicants or imposed by force ) is not valid.
That the parties are fully aware of all the implications of the conditions laid down in a contract. Any ambiguity (with the exception of ghararyasir) will make the agreement invalid. An implication is to minimize asymmetric informatiom.
That the parties are reasonably certain that they are capable of complying with all conditions of the contract. An implication of this is that sale of any goods (or services) which are not owned and possessed by the seller at the time of the contract is not valid.
That the parties intend and are committed to respect the terms of a contract both in letter and spirit. An implication of this is that any subterfuge to go around any Shariah condition through linguistic or legal tricks is not allowed.