Conventional Banks Risk Diversification: A Case for Islamic Finance

Abstract

This paper challenges the idea that the conventional financial sector either innovates or diversifies risk. To understand diversification of risk and the true nature of innovation in finance, this paper distinguishes between risk spreading and risk sharing. Risk spreading characterises conventional finance and risk sharing characterises Islamic finance. We argue that the case for Islamic type financing in the sense of risk sharing is a safer approach and overwhelming for governments, regulators and for financial institutions that consider themselves innovators in an historic sense , contributors to society rather than greedy acquisitors of personal wealth. Effectively, innovation according to the originate and distribution model of banking amounts to (a) a wealth transfer from the rest of the world to people in financial sectors, mostly in developed economies and/or (b) asset depreciation/default. We are describing a situation rather like that described by the story told to children about the emperor having no clothes . In the story , an emperor, suffering from an excess of pride or insecurity, is manipulated by an exploitive tailor into believing he has been supplied with magnificent robes that only the privileged and enlightened can see. No one dares to believe their own eyes that tell them unequivocally that the emperor is naked, except a child, who blurts out: “ why is the emperor naked ?” Why is there not a similar response to the nakedness of the financial sector, when its contribution, nationally and internationally has been so massively negative? We argue that one of the reasons is that we, meaning governments, regulators, bankers and the rest of us, are mostly divided into three groups; those who understand the mathematics of finance but not financial institutions, those who understand financial institutions but not the mathematics of finance and those who understand neither. The purpose of this paper is to examine conventional finance risk diversification and compare it to the Islamic finance risk sharing approach. The findings of this paper demonstrate that the Islamic finance risk sharing approach is safer.