Financial Engineering 1 1 Financial Engineering: An Islamic Perspective Sami Al-Suwailem IRTI, IDB Rabie I, April, 2006 Sami Al-Suwailem IRTI, IDB Rabie I, April, 2006

Financial Engineering2 Concept Finnerty (1988): Design, development and implementation of innovative financial instruments and processes, and the formulation of creative solutions to problems in financeDesign, development and implementation of innovative financial instruments and processes, and the formulation of creative solutions to problems in finance Finnerty (1988): Design, development and implementation of innovative financial instruments and processes, and the formulation of creative solutions to problems in financeDesign, development and implementation of innovative financial instruments and processes, and the formulation of creative solutions to problems in finance

Financial Engineering3 Definition Principles and strategies for developing innovative financial solutionsPrinciples and strategies for developing innovative financial solutions

Financial Engineering4 Characteristics Principles: Goals and rules for economic transactions Principles: Goals and rules for economic transactions Strategies: methods and techniques Strategies: methods and techniques Innovative: New and novel Innovative: New and novel Solutions: Satisfy real needs and create added value Solutions: Satisfy real needs and create added value Principles: Goals and rules for economic transactions Principles: Goals and rules for economic transactions Strategies: methods and techniques Strategies: methods and techniques Innovative: New and novel Innovative: New and novel Solutions: Satisfy real needs and create added value Solutions: Satisfy real needs and create added value

Financial Engineering5 State of F.E. Miller: Regulatory arbitrage Miller: Regulatory arbitrage Drucker: Products became commodities Drucker: Products became commodities Miller: Regulatory arbitrage Miller: Regulatory arbitrage Drucker: Products became commodities Drucker: Products became commodities

Financial Engineering6 Creativity Value of innovation Value of innovation Lateral thinking Lateral thinking Value of constraints Value of constraints Shariah and creativity Shariah and creativity Value of innovation Value of innovation Lateral thinking Lateral thinking Value of constraints Value of constraints Shariah and creativity Shariah and creativity

Financial Engineering7 Principles Objectives Objectives Balance Balance Integration Integration Methodology: Methodology: Acceptability Acceptability Consistency Consistency Objectives Objectives Balance Balance Integration Integration Methodology: Methodology: Acceptability Acceptability Consistency Consistency

Financial Engineering8 Principle of Balance Balance for-profit and non-profit activities Balance for-profit and non-profit activities Capitalism: market-based solutions Capitalism: market-based solutions Communism: voluntary-based solutions Communism: voluntary-based solutions Islamic Economics: balanced solutions Islamic Economics: balanced solutions Forbearance for unable debtors Forbearance for unable debtors Mutual insurance Mutual insurance Balance for-profit and non-profit activities Balance for-profit and non-profit activities Capitalism: market-based solutions Capitalism: market-based solutions Communism: voluntary-based solutions Communism: voluntary-based solutions Islamic Economics: balanced solutions Islamic Economics: balanced solutions Forbearance for unable debtors Forbearance for unable debtors Mutual insurance Mutual insurance

Financial Engineering9 Principle of Integration Integration of financial for-profit activities with real business Integration of financial for-profit activities with real business Riba: Separates finance from business Riba: Separates finance from business Gharar: Separates risk from business Gharar: Separates risk from business Murabaha: Could be applied to both Murabaha: Could be applied to both Integration of financial for-profit activities with real business Integration of financial for-profit activities with real business Riba: Separates finance from business Riba: Separates finance from business Gharar: Separates risk from business Gharar: Separates risk from business Murabaha: Could be applied to both Murabaha: Could be applied to both

Financial Engineering10 Principle of Acceptability All economic transactions are acceptable unless otherwise stated All economic transactions are acceptable unless otherwise stated Roots of prohibited dealings: Riba and gharar. Roots of prohibited dealings: Riba and gharar. Acceptability and creativity Acceptability and creativity All economic transactions are acceptable unless otherwise stated All economic transactions are acceptable unless otherwise stated Roots of prohibited dealings: Riba and gharar. Roots of prohibited dealings: Riba and gharar. Acceptability and creativity Acceptability and creativity

Financial Engineering11 Principle of Consistency Form and substance of Islamic products must be consistent Form and substance of Islamic products must be consistent Evaluation of products: Evaluation of products: Evaluate substance Evaluate substance Evaluate form Evaluate form Form and substance of Islamic products must be consistent Form and substance of Islamic products must be consistent Evaluation of products: Evaluation of products: Evaluate substance Evaluate substance Evaluate form Evaluate form

Financial Engineering12 Evaluation Substanceacceptable? no yes Formacceptable? yes Productacceptable no Product design revise

Financial Engineering13 Examples Murabaha: objective is a sale Murabaha: objective is a sale Tawarruq: objective is a loan Tawarruq: objective is a loan Murabaha: objective is a sale Murabaha: objective is a sale Tawarruq: objective is a loan Tawarruq: objective is a loan

Financial Engineering14 Strategies Where to start? Where to start? From conventional products: Imitation From conventional products: Imitation From Islamic products: Mutation From Islamic products: Mutation From real needs: Satisfaction From real needs: Satisfaction Where to start? Where to start? From conventional products: Imitation From conventional products: Imitation From Islamic products: Mutation From Islamic products: Mutation From real needs: Satisfaction From real needs: Satisfaction

Financial Engineering15 Imitation Replicate conventional products Replicate conventional products Give form priority over substance Give form priority over substance Islamic industry becomes a follower Islamic industry becomes a follower Invite alien problems Invite alien problems Produce inefficient results Produce inefficient results Replicate conventional products Replicate conventional products Give form priority over substance Give form priority over substance Islamic industry becomes a follower Islamic industry becomes a follower Invite alien problems Invite alien problems Produce inefficient results Produce inefficient results

Financial Engineering16 Mutation Start from Islamic products Start from Islamic products Genetic Algorithms Genetic Algorithms Istisna Istisna Lease-to-own Lease-to-own Value-based Salam Value-based Salam Start from Islamic products Start from Islamic products Genetic Algorithms Genetic Algorithms Istisna Istisna Lease-to-own Lease-to-own Value-based Salam Value-based Salam

Financial Engineering17 Satisfaction Start from real needs Start from real needs What does the borrower need? What does the borrower need? Cash is 10% of money Cash is 10% of money Most transactions are electronic Most transactions are electronic Money is a means Money is a means Efficiency of Islamic finance Efficiency of Islamic finance Start from real needs Start from real needs What does the borrower need? What does the borrower need? Cash is 10% of money Cash is 10% of money Most transactions are electronic Most transactions are electronic Money is a means Money is a means Efficiency of Islamic finance Efficiency of Islamic finance

Financial Engineering18 Conclusion Thinking out of the box Thinking out of the box Preserve the spirit of Islamic finance Preserve the spirit of Islamic finance Provide solutions to world economy Provide solutions to world economy Thinking out of the box Thinking out of the box Preserve the spirit of Islamic finance Preserve the spirit of Islamic finance Provide solutions to world economy Provide solutions to world economy