Commencement Address during INCEIF University 14th Convocation 2023 (4 November 2023) at Sasana Kijang, Bank Negara Malaysia.
Tan Sri Andrew Sheng
Institute for Capital Market Research
YBhg. Tan Sri Nor Shamsiah Mohd Yunus, Chancellor of INCEIF University, Yang Bhg. Tan Sri Azman Mokhtar, Chairman of Board of Directors, INCEIF University, Yang Bhg. Tan Sri Dr. Daud Bakar, Pro-Chancellor, Professor Dato’ Dr Mohd Azmi Omar, President and CEO, Honourable Members of the Board, Tan Sri-Tan Sri, Dato-dato, Professors and Students, family and friends.
I am very honoured to be invited to deliver this Convocation Speech for the Class of 2023, which is an occasion to celebrate your graduation and next step into the challenging world of jobs, further intellectual exploration and ultimately your tests in the real world. INCEIF University has prepared you as much as possible and you will remember your time at the university as one where you formed your best friendships, got to learn from everyone including your teachers, but most of all to understand your intellectual and moral direction in an uncertain world.
It would be right of many of you to ask what a non-Muslim is doing lecturing on Islamic finance. I stand in trepidation before many friends and colleagues who know much more than myself on a subject of such importance globally, nationally and individually. My credentials began when Bank Negara Malaysia under Governor Tan Sri Zeti Aziz asked me to join the founding board of INCEIF in 2006, then the International Centre for Education in Islamic Finance, today the Global University of Islamic Studies. Through the hard work of the academic staff and the strong support of Bank Negara, especially Y.Bhg Tan Sri Nor Shamsiah Mohd Yunus, former Governor, today our Chancellor, the INCEIF University has gone from strength to strength, becoming a benchmark for excellence in Islamic studies and beyond.
I was in Bank Negara during the time when the central bank embarked on Islamic banking in Malaysia through a pioneering paper in 1981 by my former colleague. Tan Sri Nor Mohamed Yakcop. I later became Chairman of the Securities and Futures Exchange (SFC) Hong Kong, where I learnt the law, rules, standards, and operations of stock markets at the international level. After I stepped down, Bank Negara asked me to become the Tun Ismail Mohamed Ali Chair (TIAC) Professor at the University of Malaya for one year. When Cambridge University Reader in Economics, the late Dr. Ajit Singh came the next year as TIAC Professor, both of us jointly wrote a paper on concepts and challenges of Islamic stock markets. I particularly learnt from my old friend from Washington days, Dr. Abbas Mirakhor on the crucial difference between risk-sharing and risk-transfers as well as Professor Rifaat Ahmed Abdel Karim, a pioneer in Islamic accounting, auditing, and regulatory standards.
In discussions on Islamic finance, there is always much to learn from my good friend, Y. Bhg Tan Sri Azman Mokhtar, Chairman of INCEIF Board and Chairman of Malaysia International Islamic Finance Centre (MIFC) Leadership Council, sponsored by both Bank Negara and Securities Commission to drive the next phase of development in positioning Malaysia as an international Islamic financial centre. He is truly a polymath in operations of financial markets, Islamic finance, philosophy and risk-taking, and I am privileged to be appointed as a member of his Council and to learn from the active discussion between the members. The Council is working hard thematically to move from the Halal Islamic Finance ecosystem to Halal and Tayyib, that is, from form to substance, from merely permissible and doing no harm to impact and doing good. This is the Council’s overarching work agenda in shifting the Islamic Finance development S curve from the Halal phase which took 40 to 60 years, to the second phase of a Tayyib eco-system. It is ideas like these that will keep Malaysia in the forefront of Islamic financial market development.
I have also tested some of my views with my former Bank Negara colleague, Y. Bhg Dato Seri Dr. Awang Adek Hussin, currently Chairman of the Securities Commission Malaysia. None of these, and many unnamed friends with whom I discussed Islamic finance and market operations, bear any responsibility for all errors and personal opinions expressed today.
I must also add an important caveat – as a non-Muslim, I cannot comment on the religious or syariah side of Islamic finance, as I am neither qualified nor able to offer any opinion. What I offer instead is one stock market practitioner and economics professional’s view of how technically an Islamic stock market can be constructed. The ideas offered are meant to be constructive and not critical of any aspect of Islamic finance.
My argument is that the technology and infrastructure for such a market is readily available. But a market is more than just its infrastructure – it is the ecosystem or human construct, comprising the people – companies that list on the exchange, the institutional players, investors, agents, intermediaries, supporting commercial services, such as lawyers and accountants and today technology experts, plus regulators – who shape how the market ecosystem thrives or simply survives. But in the end, it is the quality of the companies, their entrepreneurship and innovation, that determines whether they will outperform the competitors. If these companies are basically risk-adverse, then the stock market may only deliver the average ROE that other markets deliver. The resulting market will be only average and thus neither add nor subtract to the economic power of Islamic finance. What is true of individual companies is also true for stock markets.
But what the market seeks is Alpha, the exceptional return over the market index, which gives you the average return on capital, that is the key to success or failure and Beta, the volatility of the stock versus the market average. In the conventional stock exchange, what is sought is Return on Private Equity (ROPE), but a true stock exchange with environmental, social and governance (ESG) standards may be seeking higher Return on Social Equity (ROSE), meaning that return on social goods may differ considerably from ROPE. Pardon my puns, but ROPES can hang, whereas a ROSE is a thing of beauty.
This lecture will start from the basics of finance, particularly its history and geopolitical context, differentiating between debt finance and equity finance. The timeline of ascent of money is important because Western writers tend to attribute modern finance to the Renaissance (14-17th century) onwards. British/American historian Niall Ferguson (Ascent of Money, 2008, p.4): said “Italian bankers like the Medici made fortunes by applying Oriental mathematics to money. The Dutch Republic prevailed over the Hapsburg Empire because having the world’s first modern stock exchange was financially preferable to having the world’s biggest silver mines.”
My basic points today are as follows:
Section 1 explains that Islamic finance is an important contribution to finance theory and practice because it is equity based with ethics as its foundation. Section 2 argues that the construction of an Islamic finance depends however on practice, trial and error that cannot be built on theory alone. Theory may guide you, but the actual construction of a successful stock exchange is by trial and error, by taking risks in failure and in practice. Competition between Islamic and conventional finance will therefore depend on whether Islamic finance delivers in practice (not in theory) superior Return on Equity (ROE) and is also anti-fragile, meaning much more resilient and sustainable than conventional finance.
Section 3 argues that to obtain high performance, you will need to get alpha in terms of above average market performance. For Islamic finance to have market power relative to non-Islamic finance, it is not just a matter of basic stock market infrastructure, but the whole ecosystem of Islamic or non-Islamic companies listed on the Islamic Stock Market that have liquidity, trading volume and market capitalization larger than non-Islamic stock markets. In other words, the key drivers of stock market development are whether the local champions listed on that market outperform other markets and listed companies in terms of liquidity, stability, robustness, integrity, and creativity with morality. This general principle applies to even competition between non-Islamic capital markets. I will show how the recent innovative idea of a Social Stock Exchange can be built in Malaysia as a model Islamic Stock Exchange.
Section 4 concludes. In other words, many graduates today will go on to work in companies or financial institutions that may one day be listed, which could include Islamic stock exchanges. My basic point is that if I am not wrong, Islamic finance does not object to one being rich or high risk-taking, only that such activity should not be unethical and that once rich, the wealthy should donate to the poor, or help the next generation of start-ups, so that the ecosystem is sustainable. Your compass in life therefore is both rational and professional but ultimately moral and ethical.
Section 1: Islamic Finance is Risk-Sharing with Ethical Values
First of all, I believe there is hardly any dispute that I am aware of that Islamic Finance is all about risk-sharing with ethical values (Iqbal & Mirakhor, 2013). My own Eureka moment happened when I stood on the edge of the desert at the end of Silk Road in Dunhuang, when looking at the camel caravans, I was struck how no conventional banking could have financed the high risks of such trading routes across the desert. The risks were too huge – robbery, fraud, confiscation, lost in the desert storms etc. No amount of collateral and interest rates could have compensated for the risks involved. This was true venture capital, in which risk-sharing was the ethical foundation. You can only operate these caravans through trust, trust in God and trust in the integrity of those in the caravan.
As Abbas Mirakhor pointed out, bank-financing not only is interest-bearing, but is essentially a risk-transfer or risk-shift mechanism that can end up being predatory on the borrower, who may default through no fault of his/her own. In his elegant phrasing, risk can be mild or wild (Mirakhor and Rafi, 2017, p.93). Conventional bankers prefer mild risks, and therefore engage in risk-transfer or risk-shift, but for the system as a whole, higher leverage for the borrower or the lender only make the system more fragile. True equity finance, which shares risk with the user of the funds, makes the system more robust (anti-fragile) because both the banker and fund user have “skin-in-the-game”. The mutual incentive is to absorb the risk equitably. Islamic finance students must therefore has strong grounding in statistics and probability theory to grasp the fundamental differences in risk profile between conventional banking and Islamic finance. When power laws in risk distribution occurs (with long tails), then Islamic banking help better to manage risks.
As Mirakhor and Rafi (2017, p.v) argued in their book, Anti-fragility of Islamic Finance: “skin-in-the-game corresponds to al-ghurun-bi-al-ghurm (no gain without risk), fragility of debt and conversion of debt to equity relates to prohibition of riba (interest); risk hiding in the tail relates to prohibition of gharar (asymmetric information), speculation on the unpredictable nature of fat tail events relate to prohibition on maysir (gambling/speculation), real-sector activities correspond to encourage of al-bay (exchange) and venture capital maps almost directly to mudaraba (partnership).
The stock market is clearly a platform for risk sharing, since you own a share in the risks undertaken by the firm and the risk is symmetric, because one of the “third (basic Islamic economic) principle is that no one is allowed any gain, unless he is also subject to a loss in the process.” (Tan Sri Nor Mohamed Yakcop, 1981, p.5)
On the basic ethical values of honesty, trust and integrity that are embodied in the syariah, I take it that these are universal values, with the exception of riba. In other words, any stock market that does not violate the syariah in terms of ethical principles can be considered Islamic in principle but what matters is practice.
Section 2: Theory versus Practice
The rise of science in the 16th-17th century coincided with the rise of theory or abstract hypothesis about how the world works. In physical science, you can test your theory empirically. In social science, humans do not operate exactly like robots, and often game the rules, so that rules change over time, changing the whole social context.
Those of you who study social science will have a very different viewpoint from engineers, biologists or doctors. The former has increasingly become more theoretical, in the sense that they learn more and more about theories how the human world lives and behaves. Some of the problems today are due to the implementation of theoretical ideas without understanding how complex systems change. Many of the social theories carry assumptions that may turn out to be false or incomplete. The physical scientists must test their theories against reality – a doctor’s patient is either dead or alive. Social science is very different. Once you identify a pattern in social behaviour and you introduce a rule, the social behaviour begins to change, in what is popularly known as Goodhart’s Law: “When a measure becomes a target, it ceases to be a good measure.” Another variation of the law is that “every rule will be subject to gaming” or regulatory arbitrage. For every five-foot wall is built to stop someone climbing over, a five-foot five inches ladder will be invented.
What this means is that markets become more and more complex, like the Second Law of Thermodynamics, entropy continues to grow. If that is the case, it is almost impossible to predict precisely or replicate human behaviour, which changes with the context. This is why social systems are always innovating, what British historian Arnold Toynbee called “challenge and response”. Human beings always respond to challenges, either from nature or from other human behaviour through change. Those who do not change may not survive.
The point that I want to stress is that by definition, theory is only one out of many explanations of human behaviour – reality will not be exactly predicted by theory. That means that we cannot create financial markets, which are human constructions, through theory. It is established through trial and error and practice. Of course we can help by learning from other experience, as well as building the infrastructure and borrowing international rules and regulations. But it took 250 years to build American stock exchanges, and to expect an emerging market to replicate a NASDAQ or Silicon Valley is not so easy. Many have tried and failed.
In other words, there is orthodox or mainstream thinking, but in situation of uncertainty, one must “connect the dots” or “think out of the box”. Mainstream economic theory is still not very good at explaining innovation and entrepreneurship. There is awareness that risk-taking is critical to innovation, which is why stock markets are all about risk-taking.
Section 3: Risk-transfer versus Risk-Sharing
One must remember that banking is essentially all about risk-transfer. Let me explain about imperial finance, which is really debt financing. Money has always been issued by the state.
The first currency was coinage minted against physical metal, such as gold, silver or bronze. Up until the invention of paper currency by the Chinese, empires tended to finance wars by conquest, through loans and/or issuance/debasement of the currency. Wealth seized through conquest were then used to pay off the debts and/or to mint further currency. This conquest model drove empires from Rome to the Portuguese/Spanish empires, but the Dutch and British empires were financed through firstly domestic loans and then equity raised for chartered companies that were designed for conquest (Dutch and British East Indies Companies). As the Netherlands fell to the Spanish empire, Britain rose and created the imperial finance of today, which is to issue consolidated bonds to its colonies at roughly 2 per cent per annum to mop up wealth there and then reinvest in them through British banks, mining, plantation, and agency companies, yielding a ROE that is higher because it was also leveraged.
The United States, which supplanted the British empire and reserve currency status in 1945, has continued this financing model to this day, since the US Treasuries have become the benchmark yield against which all funding is based. Add to this the superior return of US equity, the blended ROE on investing in USD assets has essentially attracted foreign savings as a “store of value” and “means of payment”. This “exorbitant privilege” has also enabled Wall Street to function as a giant hedge fund that earns through recycling global savings for not just domestic consumption but earning superior leveraged ROE for the US. The risk or burden of the debt is ultimately transferred to those least equipped to absorb such losses, the poor and the weak. Furthermore, that injustice rests not only human beings, but also the planet in terms of damaging biodiversity, pollution and destruction of irreplaceable natural resources.
The problem is that the debt financing model has become the mainstream model of financing, which is of course not syariah compliant as it is interest-based. However, few countries, including Europe, Japan, and China, have been able to replicate the successful US stock market, which is 150 per cent of US GDP and 40 per cent of global market capitalization. Most other countries are below 100 per cent of GDP. However, the largest user of global debt is the US as its net foreign asset position as a net deficit to the rest of the world of US$18 trillion at the end of June 2023 or gross US$51.6 trillion, equivalent to 17.1 per cent and 49.1 per cent of world GDP in 2023. Since the US Government debt is now 100 per cent of GDP, a 5 per cent rate of interest on UST would mean an annual 5 per cent fiscal deficit of GDP that is clearly unsustainable. The US Congressional Budget Office’s 2023 Long-Term Budget Outlook projected that the fiscal deficit ratio would initially decline but eventually rise to 10 per cent of GDP by 2053, pushing the outstanding debt-to-GDP from 98 per cent in 2023 to 181 per cent.
In short, interest-based debt funding at usurious rates ultimately become unsustainable, even for the most powerful nation in the world. Equity funding, however, depends on continuous innovation to deliver alpha (exceptional returns), which then asks the fundamental question: how do you create the innovative companies that deliver exceptional returns? The answer is that you create an ecosystem that is open to diversity, experimentation, risk-taking and mutual trade. Since value today is related to the transformation of data to information to knowledge and finally wisdom, the ability to “monetize” technology or know-how is critical to value creation.
The best example in history was the expansion of Islam to Andalusia (today’s Spain), which occurred in less than 80 years from the Prophet Mohamed’s time, in which Islamic civilization flowered in Andalusia for nearly 800 years from 710-780 AD to 1492. The point is that huge risks were taken by the Umayyad Caliphate but clearly, they created a civilization that was intellectually, culturally and commercially open, diverse and successful.
However, companies and empires decay when they simply try to maintain the status quo, meaning that seeking the average is not sufficient as others were able to achieve higher alpha, meaning that there is superiority in efficiency as well as resilience. However, just creating alpha without taking into consideration its distributional aspects is wrong. Two factors come in – debt for consumption is not sustainable, whereas debt incurred to engage in investment that yields higher return (including social return) than the cost of funds is more sustainable. Herein lies the difference between linear and circular finance – the ROSE that is higher than ROPE is more sustainable.
The linear economy is about “make, take, waste”. In the last 100 years, 70 per cent of the global greenhouse gas (GHG) emissions are tied to material handling, use and waste (Circularity Gap Report 2023).The Report suggests that currently the world is only 7.2 per cent circular, meaning there is considerable opportunity to prioritise systemic solutions that help us use less, use longer, use again, make clean and regenerate our natural environment.
The idea of circularity already is embodied in the concept of Zakat or Wakaf, which is the giving of charity from one’s income or wealth. The idea is that those who can afford it can give to help those who cannot afford. In a sense, wakaf is a recycling of wealth, so that those who make wealth also shares with those who do not have it. The constant recycling of wealth is circular, because for a winner-take-all linear wealth generation cannot be healthy for any eco-system.
So we come to the situation of a stock market. The current stock market model is very elitist, because there are only 58,200 listed companies in the world, with 991 in Malaysia. There are 1.2 million MSMEs in Malaysia which have no access to public listing,. The cost of listings can be from 3 per cent to 7 per cent of capital sought globally, in addition to preparation of accounts, sponsorships etc. Thus, assisting MSMEs to have access to equity capital would be within the goals of Islamic finance, financial inclusion, reduction of their debt/equity leverage (financial resilience) and contribution to jobs and ESG.
How does one construct an Islamic Stock Exchange?
In the past, development banks and financial institutions have tried hard, but have not succeeded well, because many are sectoral, specialized and do not work together well to provide the total eco-system support for MSMEs. In my view, giving loans to companies already burdened with debt do not necessarily help them. More often than not, it is knowhow, technology, marketing and financial expertise that would be more appreciated than just money. We must understand the broader eco-system entangled barriers to growth, rather than focus on narrow issues, like trying to find the silver bullet to a general system problem.
The solution to construction of an Islamic Stock Exchange at the broader level was solved by the Indian concept of a Social Stock Exchange (SSE). In 2022, the Securities and Exchange Board of India (SEBI) announced the creation of a SSE through the brilliant innovation of the trading of a Zero-Coupon, No-Return Instrument. This is legally a charity donation, since the buyer does not expect a coupon return, nor capital gains from buying this instrument. What the SSE does is to use the existing infrastructure of the stock market listing, trading, clearing and payment system to trade a donation instrument for worthy or eligible social enterprises.
What do we mean by social enterprises? These are all enterprises (firms or non-governmental organizations) which try to do social good and do not necessarily make a profit. In other words, social enterprises care about social good than just private good. For example, the bulk of mom-and-pop family businesses do not make much profit, but they often earn enough to keep the family jobs, pay for food, health and retirement – they contribute to employment, and with initiative and innovation; they are the diverse mass creativity that adds to growth and change. The SSE is the platform that matches social enterprises who need capital and those who are willing to donate to those enterprises who fulfil their social objectives. You can roughly divide social enterprises into those that create impact (impact investing with potential for upside profits) and those which are likely to be pure charity or donation cases.
Essentially, social enterprises who seek capital can go through the same listing process on the SSE using the same public accountants (who do this out of ESG efforts). The investors get a transparent and accountable assessment of which social enterprise is delivering on their promises, and which do not. The SSE listed social enterprises are subject to a disciplinary process whereby they must deliver what they promised, not necessarily in profits, but in social good. The SSE is the market-design platform that matches the supply and demand for social good.
My belief is that the SSE fulfils the conditions of an Islamic Stock Market, because it institutionalizes the process of zakat or spirit of wakaf.
Foundationally, the SSE is the eco-system whereby we allow innovation and creativity through mass experimentation. Exactly like Silicon Valley, we do not know which tech start-up will succeed, but putting them through the VC/PE process of selection, grooming and incubation, some will become unicorns. In this process, social value is created and if private value or wealth is created, the proceeds are recycled back to the next round of creativity and social good.
Before I conclude, let me address a question posed to me by Tan Sri Azman – “where is the source of the risk capital and / or philantrophic capital going to come from – and at a scale that will make a difference”.
Hitherto, the government has taken the approach to either provide seek capital for venture capital itself or ask the government-linked financial institutions to take alternative assets in their portfolios. There are limits to such funding.
There are also limits to zakat funding, which is about RM 5 bn annually. My point is that Malaysia is not a country short of saving, since the country runs a current account surplus year after year. The reason why BNM foreign exchange reserves have not increased despite current account surpluses and high savings relative to income, is that capital outflows occur annually. If the private sector perceives that foreign assets have higher total return (capital plus dividend) than investing domestically, there will always be capital outflows. Thus we get back to the chicken-and-egg problem of which comes first – the yield or the stock. If yields are high, there will be more investments and vice versa. This is why I feel that it is important to get the private sector more room to invest, especially the treatment between domestic investors and foreign investors, the latter is often more welcomed through tax incentives and licences to import foreign labour.
Since the market is pricing equity in tech or knowledge-based companies better than pure resource-based equity with higher Price-Equity Ratios, then the equity market will be driven by highly attractive and profitable companies that generate profits from technology and innovation. The current US stock market boom is really driven by their Magnificent Seven tech companies, even though at the macro-level, growth has slowed. Hence, I am less attracted to using government funding and more focused on nurturing or inculcating new local startups that can deliver superior alpha in terms of both ROPE and ROSE.
Malaysia is a small economy in relative terms, and given the liquidity of global funding in search of long-term returns, the priority to open up the private sector to more market competition through innovation and digitization is clearly the way to go. My point is that much less natural-resource endowed countries like South Korea and Taiwan have developed strong tech-based economies without funding issues. This is because they developed the eco-system of having high-tech expertise in financial institutions and government who understand how to nurture the next generation of tech champions. Talent building through very strong technical universities provided the engineers that created the chips that TSMC create in order to become number one in semiconductor manufacturing. Markets are human-built – its ultimately all about people, talent and rewarding risk-taking and entrepreneurship and innovation.
Section 4: Concluding thoughts
Having taken you through my thoughts on how to create an Islamic Stock Exchange via the mechanism of a SSE, let me sum up. I do not pretend that I know how to pick winners or champion enterprises. All I know from experience is that we must create the diverse eco-system which will grow them through a disciplined process of transparency, accountability and integrity. We hardly need extra changes in taxation or mechanisms, only policies and programmes that reduce the transaction costs of MSMEs, so that they have a more level playing field against giant institutions.
Let me now return from this serious subject to a more personal message for INCEIF graduates.
Each of you have been endowed by natural talent from your parents and from God, with all their advantages or disadvantages. Your passage through INCEIF University is a process in which your teachers and friends you make helps to shape and prepare your journey in life. I have a favourite personal observation in my mentorship of my younger colleagues. I may be your coach, but you yourself must run the race of life.
In my humble view, the principles of all religions are in many ways universal in that they teach you to be good, creative and cooperative – to care and share, and to be just. My mentor in central banking, the late Tun Ismail Mohd Ali, said that the role of central bankers is to be professional with integrity and competence, independent not of government but within government. Your job in life is to achieve in your career the best you can, the most professional you can with your moral anchor in your values and a clear conscience. A key lesson I learnt after a life of professional rationality in the midst of the pandemic and geopolitical conflict is that every decision is a moral decision, irrespective of scientific rationality or otherwise. This is because as long as we live within social communities and within the planet earth, we are part of humanity and part of nature, not above anyone else. This is a world full of life and emotions, love and hate, your ambition may be at the cost of someone else’s future.
The rite of passage as a graduate therefore ultimately is accountability, because throughout your life and at the end of every life, we will be judged – good deeds will be rewarded, bad deeds will be punished. If you walk in life, caring, sharing and justly, the faith that INCEIF, your teachers, parents and supporters would be more than justified and fulfilled. But ultimately, it is your conscience before God that matters.
You are the blessed generation; be grateful what you have been given and fulfil the trust we all have in your future, which is yours to walk and create.
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 Based on available data from 24 developing member countries (DMCs) of the Asian Development Bank (ADB) through 2022, MSMEs accounted for an average 96.6% of all enterprises, 55.8% of the workforce, and 28.0% of a country’s economic output. In Malaysia at end 2021, they accounted for 97.4% of enterprises, 47.8% of employment, 25.2% of exports and 38.1% of GDP.
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 Gunasegaram, P. 2018. Tun Ismail Ali: Paragon of Trust and Integrity. Malaysia: Bank Negara Malaysia, 2nd edition. I would be remiss if I do not include amongst my mentors Tan Sri Aziz Taha, former Governor, Bank Negara, known for his integrity, professionalism and willingness to sacrifice for the public good. I will be forever grateful for his guidance to me during some of the most testing days of my career.