Islamic Capital Markets and Products

CHAPTER 12Malaysia's Islamic Capital Markets – A Case Study

By Obiyathulla Ismath Bacha and Daud Vicary Abdullah

The capital market plays a very important role in modern economies. Being a part of the financial sector, which it shares with the banking system, capital markets have become the focus of many a government's development plans. Most developing countries' financial sectors tend to be dominated by the banking system. Banks as intermediaries between depositors (surplus units) and borrowers (deficit units) offer indirect financing, in the sense that the depositor has no idea who has borrowed their money, nor the type of project their money has gone into. The bank takes on the intermediation risk in return for the interest spreads. This concentrates risks on a few banks, results in a knife-edge equilibrium and makes the overall economy vulnerable. Governments realising this have started to build capital markets which while also being an intermediary, do it in a way that does not concentrate risk. Capital markets unlike banks require direct financing. That is, the investor, by buying stocks or bonds, has direct exposure to the underlying firm with nothing inbetween. Risks do not get concentrated, but get spread out over a large number of individual/institutional investors. Relative to banks, therefore, the contingent liability to governments from capital markets is much less, in fact almost nothing.

In addition to intermediation, capital markets can be part of the payments ...