Allah Works in Mysterious Ways Especially in the World of Finance:

An argument that social constructivism better explains the challenges of accountability

that Islamic finance poses international regulatory institutions better than neoliberalism

LO, Stephen Andrew Kai Tai

POLI 344 A03
Dr. Bartholomew Paudyn
August 12, 2010
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I. Introduction
i. Allah Works in Mysterious Ways: Especially in the World of Finance

With its origins in the late 1970s, as an amalgam between traditional Islamic

ethics and modern bourgeois enterprise, Islamic finance, with rapid growth rates (of 10-

15% annually in the 1990s and 2000s), greater profit margins, and innovative financial

engineering, has been one of the fastest growing sectors in the international financial

industry for the past decade (Henry & Wilson, 2005: 2; Khaf, 2005: 22; Modi, 2007: 38).

However, the Islamic financial industry has not successfully achieved a state of financial

harmonization (Modi, 2007: 38), yet it remains poorly understood in both the Middle

East and the West (Henry & Wilson, 2005: 1-3). Unlike conventional financial tools,

Islamic finance is a sector of the financial industry that is theoretically supposed to

conform to strict ethical standards imposed shari’a (Islamic religious) law and rulings,

which prohibit any financial transactions that are considered haram (not meeting shari’a

standards) (Modi, 2007: 38). Islamic finance is also a sector that is still relatively young

in the financial world, and the lack of harmonization and standardization in Islamic

finance poses a major challenge to the proper regulation of the Islamic financial industry

(Hassan & Lewis, 2007: 1-2); this begs the question: Why does social constructivism

explain the existence of regulatory challenges in accountability of Islamic financial

institutions to international institutions better than neoliberalism? With this question in

mind, the reader will observe that this essay argues that social constructivism explains the

absence of a harmonized regulatory regime of Islamic finance better than neoliberalism

especially in the field of corporate accountability, i.e., Islamic financial institutions being

able to honestly account for the operational procedures and investment decisions made on
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behalf of their investors.

ii. Structure of the Argument

Before defending the position that this essay argues for, this subsection will show

the basic structure of this essay. This essay is structured into three sections: I.

Introduction, II. Body, and III. Conclusion: Accommodating Differences in

International Financial Regulation Rather than Coloring the World with One

Monochromatic Brush.

I. Introduction is divided into two subsections: I.i. Allah Works in Mysterious

Ways: Especially in the World of Finance, and I. ii. Structure of the Argument.

Subsection I. i. introduces the significance of Islamic finance to international political

economy by giving the reader a general view of Islamic finance in the world. I. ii. is an

outline of the how this essay presents the argument: Why does social constructivism

explain the existence of regulatory challenges in accountability of Islamic financial

institutions to international institutions better than neoliberalism?

II. Body is divided into three subsections: II. i. The Theories of Neoliberalism

and Social Constructivism, II. ii. Understanding the Governance of Islamic Financial

Institutions and II. iii. The Neoliberal Failure of Regulating Islamic Financial

Institutions. II. i. introduces the reader to the basic premises of the theories of

neoliberalism and social constructivism. II. ii. exposes the reader to the regulatory

structure of Islamic financial governance, and shows that the governance of Islamic

finance is deeply rooted in religious and cultural factors, and that regulating the

accountability of Islamic financial institutions proves challenging especially in fields of

risk mitigation, shari’a compliance, governance power of investors and transparency. II.
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iii. provides further evidence to show that Islamic financial institutions have, by and

large, escaped regulation and monitoring by international regulatory agencies such as the

Islamic Financial Services Board, the International Monetary Fund, the Basel Committee

for Banking Supervision (BCBS), the International Convergence of Capital

Measurement and Capital Standards: a Revised Framework (Basel II), etc..

III. Conclusion will conclude the essay by exposing the failure of neoliberalism

in explaining the regulatory challenge that Islamic finance poses the world of finance,

especially in accountability, and that social constructivism better explains these

phenomena. This section also gives recommendations to further integrate and harmonize

Islamic finance in international political economy in a manner where investors are better

protected, while shari’a law is observed in Islamic finance.

II. Body
i. The Theories of Neoliberalism and Social Constructivism

Neoliberalism is an analytical theory premised on rationality and contracting to

study the centrality of institutions and organizations in international politics, and their

role in resolving collective action problems (Martin, 2007: 110, 118, 124). Neoliberal

analysts tend to use a principal-agent framework to study how international organizations

and institutions function deliver their mandates (Martin, 2007: 124). This perspective

posits that international institutions monitor, provide assurances that agreements will be

met, and serve as forums where different parties can communicate problems that arise in

coordination and be informed of preferences and constraints that they face (Martin, 2007:

111).

Social constructivism is a theory that has a different ontological approach vis-à-

vis neoliberalism, and is premised on the notion that phenomena, which are socially
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constructed, occur across context rather than a single objective reality (Fierke, 2007:

168). Social constructivism puts an emphasis on the importance of holistic ideational

factors in international phenomena such as norms, rules and language rather than on

rather constant individualist-materialist factors such as monetary reserves and balance

sheets (Cohn, 2010: 114-116; Fierke: 2007: 168; Wendt, 1999: 371). When using social

constructivism to analyze issues in international political economy, epistemic

communities and the influence of the norms and values that they project in governance

are central (Cohn, 2010, 114-116).

ii. Understanding the Governance of Islamic Financial Institutions

Islamic finance exists as an alternative to conventional banking by adhering to

norms that are acceptable under Islamic shari’a law (Hassan & Lewis, 2007: 2). Islamic

finance, when practiced in a hallal (in accordance to shari’a law) manner, strictly

prohibits riba (excess, i.e. interest and usury), maysir (gambling and speculation), and

gharar (unreasonable uncertainty), and requires that Islamic financial institutions benefit

society through the collection of zakat (almsgiving), which is overseen by a special

religious supervisory board, so that operations would help create a fairer and more

equitable society (Hassan & Lewis, 2007: 2-3; Algaoud & Lewis, 2007: 38-47). Islamic

finance, therefore, does not use interest at predetermined rates, but instead operates on a

regime of profit and loss sharing, where investment accounts offer money lending

services and returns that are competitive with those of conventional finance (Algaoud &

Lewis: 47).

Islamic finance has a different set of financial tools from their conventional

western-style counterparts. The bedrock of Islamic financial mediation is the mudarabah

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(investment) contract (van Greuning & Iqbal, 2007: 16-17). Investors would deposit their

money into their investment account for the Islamic financial institution to manage by

lending money to other enterprises that will use the money in asset-backed financial

claims or profit sharing and loss bearing schemes (van Greuning & Iqbal, 2007: 22).

However, there is a tendency for investors, and as a result, Islamic financial institutions,

to be conservative in the profit sharing and loss bearing schemes, which have few

institutional infrastructures to such schemes (van Greuning & Iqbal, 2007: 22). This

contractual institution in Islamic financial institutions creates a situation where

depositors/investors are acting as if they were shareholders of securities (van Greuning &

Iqbal, 2007: 22-23).

With this alternative financial model, Islamic finance has, at present, its plethora

of regulatory structures such as the Islamic Development Bank Group, Accounting and

Auditing Organization for Islamic Financial Institutions, Islamic Financial Services

Board, etc. Under the leadership of the Islamic Development Bank, and with the support

of the World Bank, IMF and the Basel Committee, there has been a push towards a

strengthening of the regulatory structure of Islamic financial institutions through greater

regulatory harmonization (Iqbal, 2007: 382). However, these regulatory reforms face the

unsavory possibilities of having regulatory agencies duplicate regulatory competences

and being whitewashed in order to be regulated with conventional financial institutions

(Iqbal, 2007: 382).

iii. The Neoliberal Failure of Regulating Islamic Financial Institutions

Another challenge that regulators of Islamic finance also face problems of

corporate accountability. Islamic finance is based on the adherence to shari’a law, and
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has cultural particularities that do not exist in conventional banking (Bahmbra, 2007:

203-204). Risks that are identified in Islamic finance, such as defaulting debtors might

not be as easily resolved as in conventional banking due to shari’a law, since penalty

clauses are haram (Bahmbra, 2007: 203). Non-compliance with shari’a, also tarnishes

the confidence of investors of the Islamic financial institution or even towards the

industry itself, and requires a Shari’a Supervisory Board to ensure compliance with

shari’a practices by issuing rulings and fatwa, which need to be circulated and

implemented by the firm (Bahmbra, 2007: 205). Holders of investment accounts with

Islamic financial firms have far less governing powers than investment accounts of

conventional financial firms, since the investor has no governance over how the money is

invested, unless he or she terminates the mudarabah contract that he or she has with the

Islamic financial institution (Archer & Karim, 2007b: 320). There is also a lack of

transparency in how accounts are managed, and as a result, investors might not have

enough information to make informed investment plans when putting money into their

Islamic financial contracts and to be ensured that the Islamic financial institution is sound

and operating in an honest and disciplined manner within the confines of the market

(Archer & Karim, 2007b: 328-329).

On another note, Islamic financial institutions are normally regulated by national

central banks, and are usually treated not too differently from conventional commercial

banks, even though their business models are rather different (Archer & Karim, 2007b:

333). This approach is problematic because most central banks tend to protect depositors

more than investors, while most Islamic financial institutions tend to have a convoluted

conception of investor and depositor, where profit is involved (Archer & Karim, 2007b:
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333). It is very likely that Islamic financial institutions would require a different

regulatory approach from what is presently practiced that both treats Islamic financial

institutions both as banks and securities (Archer & Karim, 2007b: 333-334).

Another challenge that Islamic financial institutions provide the international

regulatory regime is that Islamic financial institutions do not fall neatly under Basel II,

which was introduced by the BCBS to better mitigate risks, ensure financial stability,

increase market confidence and provide investors with reliable information about the

health of financial institutions. Basel II is divided into three “Pillars”. Pillar 1 provides

new solutions to credit risk from the operational risks outlined in the 1988 Capital Accord

(Basel I). Pillar 2 addresses the supervisory review process from the perspective of the

responsibility of the supervisor to promote the stability of the banking system, set up

common guidelines for supervisory review and the importance of dialogue between

supervisors and banks. Pillar 3 outlines the minimum number of public reporting

standards on risk and risk management so that market participants can be aware of a

bank’s risk profile and the adequacy of its capital relation to the bank’s risk profile,

thereby involving the market in the capital adequacy regime (Archer & Karim, 2007a: 2).

There remain major challenges in ensuring that Islamic financial institutions do

not take excessive risks that could potentially destabilize the Islamic financial industry

under Pillar 2 such as terrorism, legal risks especially in instances that are precedent

setting or require litigation (Nakajima & Rider, 2007: 342-343, 350, 357). Under Pillar 3,

regulators face challenges in ensuring transparency via information disclosure that must

be credible so that investors could make informed investment choices and ensure that

Islamic financial companies adhere to the regulations to which they are subject to so that
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investors and regulators can name and shame, and impose sanctions on the governing

bodies of Islamic financial institutions that do not follow the regulations (Abdullah, 2007:

377-378). Norms and best practices will need to be introduced to ensure that Islamic

financial institutions function in an responsible manner without taking excessive financial

risks especially when such norms and best practices are not yet in place.

III. Conclusion

After reviewing the dynamics in the regulation of the Islamic financial

institutions, it is very clear that Islamic finance, as an industry, though full of regulatory

challenges in regards to accountability, is firmly rooted in the traditions and ethical

framework of shari’a law and ruling, which are the norms that devout Muslims adhere to

in their daily dealings in the world. These ideational factors are of utmost importance in

the institutionalization of norms and practices in the relatively new industry of Islamic

finance, especially when the regulatory structure in place is not strong enough to properly

regulate the industry. Islamic finance, although quickly growing does not rely on the

financial tools available to conventional finance, especially those that bare interest,

thanks to the norms that religious scholars and Islamic financial traders have decided to

adhere to in the industry. This shows that in Islamic finance, norms and values are far

more important than profits that are made from a purely rational-choice perspective,

especially when Islamic financial institutions have an aversion to practices that are

normally considered acceptable and perfectly legal in conventional finance.

From these observations, it is apparent that neoliberalism, which is premised on

rational choice and the role of institutions acting as a forum where problems of

coordination, regulation, insufficient confidence, communications of preferences and

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restraints are resolved, fails to explain the peculiarities of the accountability of the

Islamic financial industry which challenges the transnational neoliberal regulatory

regime, especially when Islamic financial institutions are not just-for-profit institutions

that have a duty to give back to society. Social constructivism, on the other hand, takes

into account the cultural and ethical tendencies that helped construct the Islamic financial

industry, as well as the still-under-construction regulatory regimes that still have

immense regulatory gaps that still need to be closed but not duplicated and best practices

that still have yet to be determined.

On afterthought, although the fast-growing industry of Islamic finance requires

more effective regulation, greater harmonization and standardization and a different

regulatory approach vis-à-vis conventional banking, these norms and regulations cannot

be implemented without expert advice formed in the epistemic communities of mullahs,

financiers and central bankers. If Islamic finance is to be a force in international political

economy that will be of great significance, international organizations and other

supervisory bodies need to modify their regulatory practices so that the Islamic financial

industry would be properly monitored and become more transparent, thus providing

investors with sound information, and be able to manage risks more effectively. These

proposed changes in financial regulation can pave the way to a global financial system

that operates more efficiently while allowing for greater diversity and choice for investors

who are conscious of ethics and norms. This essay strongly defends that social

constructivism, an ideational theory, better explains the changes that the Islamic financial

industry is going through in terms of corporate accountability and regulation than

neoliberalism, a substantive theory based on rational-choice, i.e., profit-maximization.

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After observing these points, other questions that the argument of this essay can lead to

are: Do neoliberal institutions stifle innovations that exist in the free market because of

bureaucratic dogma and inefficiency? Does financial reform and harmonization require

an ideational shift?
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