The Islamic Financial System 121
If we assert that Islamic fi nance is all about risk sharing, then the best
instrument for this is a stock market “which is arguably the most sophisti-
cated market - based risk - sharing mechanism” (Brav et al. 2002). Developing
an effi cient stock market can effectively complement and supplement the
existing and future array of other Islamic fi nance instruments. It would
provide the means for business and industry to raise long - term capital. A
vibrant stock market would allow the risk diversifi cation necessary for man-
aging aggregate and idiosyncratic risks. Such an active market would reduce
the dominance of banks and debt fi nancing where risks become concen-
trated and create system fragility (Sheng 2009).
Idiosyncratic risks have a potential impact on the liquidity of individuals.
With an active stock market, individuals can buffer idiosyncratic liquidity
shocks by selling equity shares on the stock market. Firms too can reduce
their liquidity risk through active participation in the stock market and can
reduce risks to the rate of return to their own operation — such as productiv-
ity risk — by holding a well - diversifi ed share portfolio. Thus incentives are
created for investment in more long - term, productive projects. Importantly,
by actively participating in the stock market, individuals and fi rms can miti-
gate the risk of unnecessary and premature liquidation of their assets due
to liquidity and productivity shocks (Pagano 1993). Moreover, an active
and vibrant stock market creates strong incentives for a higher degree of
technological specialization, through which the overall productivity of the
economy is increased. Without suffi ciently strong risk sharing through par-
ticipation in the stock market, fi rms avoid deeper specialization, fearing the
risk from sectoral demand shocks (Saint - Paul 1992).
The reason stock markets are such an effective tool for risk - sharing
purposes is that each share represents a contingent residual equity claim. In
the case of open corporations, in particular, their common stock are “pro-
portionate claims on the pay offs of all future states” (Fama and Jensen
1983). These returns are contingent on future outcomes. Stock markets that
are well - organized, regulated and supervised are effi cient from an economic
viewpoint because they allocate risks according to the risk-bearing ability
of the participants. A solution to the problem of how best to allocate the
risks of the economy was provided by the famous Arrow - Debreu model
of competitive equilibrium (1954; see also Arrow 1972). According to this
model, effi cient risk sharing requires that the risks of the economy are allo-
cated among participants in accordance with their “respective degree of risk
tolerance” (Hellwig 1998).
An economy in which there are contingent markets for all commodities —
meaning that there are buyers and sellers who promise to buy or sell given
commodities “if any only if” a specifi ed state of the world occurs — is known
as an Arrow - Debreu economy. In such an economy, it is the budget constraint
of the participants that determines how much of each contingent commodity
they can buy at prevailing market prices. Since these commodities are contin-
gent on future states, they are risky. Therefore, individual budget constraints
determine the risk - bearing ability of each market participant. Arrow himself