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Working Paper: Enhancing Islamic Finance: Establishing an Islamic Stock Market that Overcomes Problems of the Existing Stock Market Regime

Working Paper: Enhancing Islamic Finance: Establishing an Islamic Stock Market that Overcomes Problems of the Existing Stock Market Regime

Posted on Thursday 8th May 2014

Conventional stock exchanges have not produced sound corporate governance nor raised capital for small and medium enterprises (SMEs). This paper assesses the merits of establishing Islamic stock markets to address these shortcomings.

Introduction

This paper is a sequel to the 2012 Sheng and Singh article which identified and explained the significance of the two central tenets of Islamic Finance, namely its underpinning by a strong ethical system and the absolute prohibition of the use of interest rates. It was also argued in that paper that the cooperation between the conventional western system and the Islamic system is eminently sensible and will lead to a Pareto optimal increase in world welfare.

Our earlier paper concluded that Islamic Finance has been growing at a fast rate over the last two decades. It is a complete system that has the potential to satisfy the financing and banking needs not only of Muslims worldwide but also of non-Muslims in various countries. It offers the world an additional financial system favouring profits derived from capital and labour working together, rather than interest, and with a rather different ethical basis than that under current Western capitalism.

This paper looks at a much narrower, but current issue of establishing and operating Islamic stock markets within a global context. Islamic stock markets would compete against non-Islamic markets. If Islamic stock markets are successful, they will strengthen and enhance the international appeal and practice of Islamic finance. Leading Islamic scholars have long argued in favour of Islamic stock markets, even though they recognise that many practices in conventional stock markets may be incompatible with Islamic teaching. In 1984, Professor Metwally observed: "In an Islamic economy where interest bearing loans are prohibited and where direct participation in business enterprise, with its attendant risks and profit sharing, is encouraged, the existence of a well-functioning Stock Exchange is very important. It would allow for the mobilization of savings for investment and provide means for liquidity to individual shareholders.

However, existing Stock Exchanges in non-Islamic economies have many drawbacks. They generate practices such as speculation and fluctuations in share prices which are not related to the economic performance of enterprises. These practices are inconsistent with the teachings of Islam."

The global financial crisis has refocused attention on the role of financial markets, including the stock market, in economic development.  The crisis has highlighted serious shortcomings, such as short-termism, misaligned incentives, and a breakdown in trust in the current model.

This paper was published in 2012 under the University for Cambridge Centre for Business Research.

The views expressed in this working paper are the authors' own and do not necessarily reflect Fung Global Institute's editorial policy.


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