Thursday, August 21, 2014
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The Challenge of Islamic Finance

HONG KONG – With Britain now in talks to sell part of the government’s 82% stake in the Royal Bank of Scotland to Abu Dhabi sovereign-wealth funds, the Islamic world’s growing financial clout is once again on display. That clout also poses a systemic challenge to the dominant way that finance is now practiced around the world.

From humble beginnings in the 1990’s, Islamic finance has become a trillion-dollar industry. The market consensus is that Islamic finance has a bright future, owing to favorable demographics and rising incomes in Muslim communities.

Despite skepticism regarding accommodation between Islamic and global finance, leading banks are buying Islamic bonds and forming subsidiaries specifically to conduct Islamic finance. Special laws have been enacted in non-Muslim financial centers – London, Singapore, and Hong Kong – to facilitate the operation of Islamic banks and associated financial institutions.

How should these developments be viewed from the perspective of Western finance and mainstream economic analysis? Does Islamic finance really constitute a viable alternative financial system?

The very fact that such a question is asked nowadays is significant. Not so long ago, Islamic finance was superficially dubbed a zero-interest-rate system that would lead to inadequate and inefficient resource mobilization and utilization. Ironically, mainstream central bankers today routinely use precisely such policies when pursuing massive “quantitative easing.”

There are two central precepts of Islamic finance: absolute prohibition on charging interest on financial transactions, and high moral standards on the part of lenders and borrowers. Interestingly, the best economic rationale for a zero-interest-rate system is provided in John Maynard Keynes’s The General Theory:

Provisions against usury are amongst the most ancient economic practices of which we have record….In a world, therefore, which no one reckoned to be safe, it was almost inevitable that the rate of interest, unless it was curbed by every instrument at the disposal of society, would rise too high to permit of an adequate inducement to invest.”

Keynes suggested that only a very low or zero interest rate could ensure continuous full employment and distributional equity. Keynes’s endorsement of such a policy does not necessarily make it right, but his analysis does suggest that it should be regarded as a serious proposition.

Importantly, although interest is prohibited under Islamic finance, profit is not; the latter is derived from various arrangements that combine finance and enterprise. In essence, this is a profit-sharing and risk-sharing system that is based entirely on equity finance.

Islamic finance thus contrasts with the current dominant system based on interest-bearing debt, in which risks are theoretically transferred to debt holders, but in practice are socialized during crises. Other things being equal, most economists will agree that debt finance leads to greater instability than equity finance.

It follows from the second major tenet of Islamic finance that if people adhered strictly to its ethical requirements, there would be fewer moral-hazard problems in Islamic banking. Moral hazard exists in all systems in which the state ultimately absorbs the risks of private citizens.

But, whether any particular system is efficient in avoiding moral hazard is a matter of practice, rather than of theory. Many would agree that, historically, Christian morality played an important role in the rise of Western capitalism. Secular capitalism, however, has experienced an erosion of values, whereby the financial sector has put its own interests above those of the rest of society.& If the ethical values in Islamic finance – grounded in sharia religious law – can further deter moral hazard and the abuse of fiduciary duties by financial institutions, Islamic finance could prove to be a serious alternative to current models of derivative finance.

Moreover, the basic tenets of Islamic finance force us to re-think the ethical basis of modern monetary arrangements, which have evolved into a global reserve-currency system founded on fiat money. In the past, gold had been the anchor of monetary stability and financial discipline, even if it was deflationary.

The test of any alternative financial system depends ultimately on whether it is – or can be – more efficient, ethical, stable, and adaptable than the prevailing system. For now, there is no Islamic global reserve currency and no lender of last resort. But the Islamic world is the custodian of huge natural resources that back its trading and financial activities.

As the Islamic world grows in stature and influence, Islamic finance will become a formidable competitor to the current financial system. The world would have much to gain if the two systems were to compete fairly and constructively to meet people’s needs for different types of finance.

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  1. CommentedWaleed Addas

    Islamic finance must also be seen as inseperable from all the other components regulating human activities under the Sharia'h, i.e it is part of a complete system of life. However, in practice the key challenge facing Islamic finance providers is that most of them function within the confines and rules of the conventional/secular system, and as a result some 'immitation' takes place inadvertently as a consequence of association. So far the true spirit of Islamic finance (mudarabah) has still not come out of the box because of this major systemic risk and challenge as it represents a very tiny share of the size of the Islamic finance industry. Once Mudarabah is enabled to fully come out and reach its potential, then the world of global finance will be transformed forever.

  2. CommentedKaleem Alam

    Mr. Andrew and Mr. Ajit have not raised anything new, Islamic finance is on move and all are recognizing it.

    Keynes or other leading western economist in past or present have not developed or talked of total usury free economy. Off course here and there has been talk of near zero, but there is permissibility. Whereas Riba-usury is prohibited in Islam in “toto”. The Holy Quran declares war against Riba – usury. It was prohibited to the Jews and Christians as well, but Jewish leadership permitted Jews to be practice usury with non-Jews. And Christians got it permitted for good causes, but in Islam even for most noblest of noblest cause you cannot practice usury. As Islam claims to be religion for all, it does not discriminate against anybody.

    It was due to Islamophobies that the great and noble direction of Islam was misguided to general masses of the world. Islam has complete system, a complete way of life, and is Islami is fully integrated religious, political, economics & business, manners etc. in it, only if people understand.

  3. CommentedMabid Ali Al-Jarhi

    I would like to remind Andrew and Ajit that the main problem with a financial system based on the rate of interest can be found in the work started by Paul Samuelson and Milton Friedman on the the theory of the optimal supply of money that dates back to 1969. The theory indicates that positive rates of interest lead to people's economizing on the use of money in transactions. This leads to substituting real resources for money in transactions, e.g., more trips to the bank by business and households. Output would be less, and economic efficiency suffers. Only at a zero rate of interest can the economy be efficient, as there would be no incentive to substitute real resources for money in transactions. Unfortunately, there is no easy policy that keeps the rate of interest at zero level (remember the liquidity trap of Keynes too).
    Islam provides an alternative and more efficient solution to the use of the classical loan contract. It provides twelve alternative contracts for financing and investment. The revival of such contracts in the last part of the Twentieth Century may be the best contribution Muslims have made to human civilization in our time.

  4. CommentedSami Al-Suwailem

    Islamic finance prohibits interest on lending, but a markup on sale or trade is legitimate. The phrase the authors use, "absolute prohibition on charging interest on financial transactions" therefore is not very accurate. Islamic finance does recognize time-value but only in trade and production, not in money-for-money.

    Prohibiting interest on loans prevents divergence of finance from real activities. But financial needs of the society still need to be met. Not all forms of debt are bad. We need a formula that distinguishes healthy debt, needed to finance creation of wealth, from bad debt that destroys it.
    This formula lies in the integration of financing with real economic activities, as in equity financing, leasing, and mark-up sale (sale with a deferred price payment). Mark-up sale is particularly instructive on the difference between interest-based loans and sale-based debt.

    Both an interest-based loan and a mark-up sale create a debt, and both include a time-value premium. But an interest-based loan is structurally decoupled from real economic activities. A loan can be used to purchase goods and services, or to refinance outstanding debt. During the housing boom in the U.S. (2002-2007), the majority of sub-prime mortgages, more than 70%, were used for refinancing.

    In a mark-up sale, in contrast, debt is created solely for the purchase of goods and services. It integrates debt creation with real transactions required for wealth creation. In this manner, debt is structurally imbedded into productive activities, and thus is used to serve the economy rather than the other way around. Mark-up premium reflects time-value but without allowing for debt to grow on its own as it is the case in interest-based lending.

  5. CommentedUsamah Uthman

    Actually, Keynes was not alone in his position on the interest rate.In The Theory of Economic Development, Joseph Schumpeter remarked that "interest acts as a tax upon profit." For an elaboratiion on this remark, see http://faculty.kfupm.edu.sa/FINEC/osama/Scumpeter%20The%20Tax-like%20Effect.pdf

  6. CommentedUsamah Uthman

    Keynes was right. Imagin that all interest -based financing was abolished from the economic system, and equity- akin finacing was the only alternative. In that case an important contractual element of cost to borrowers ( the interest charges)has been removed. Consequently, return on equity will be higher, the opportunity cost of hoarding money will be higher. The financiers shall be inticed to invest more, not less!

  7. CommentedJonathan Lam

    Gamesmith94134: Islamic Finance unbound

    IMF would urge BRIC and emerging nations set up funds for the settle the near crisis, and some would suggest the write-off for those debts; but how could one give away money for uncertainty? At present, I would propose a “Seven Percent Solution” which will balance the low interest payment and build up the assets for the sovereignty debtors in the 3% coupon for tax and 3% equity build up through investment; plus 1% insurer fee for the global observers who run its development and collect repayment. For example:

    would you put your asset in the 10 million Euro worth of bonds in full to the World Bank which garantees a 3% annum in coupon? The coupon to you is tradable in open market to your exporters, and serves for tax credit to your nominated soveriegnty nation like Greece, and the 10 million Euro worth of bonds is withheld a parcel which the World Bank will guarantee Greece will return in full parcel in nominated currency or equity applied. Since the parcel may not adequately applied with equity or privatized assets, such parcel will come through arbitration by World Bank to ensure Greece will comply with integrity for its liabilities. Thereon, the quarterly payments of 4% will come from Greece that 1% no- refunable applies to the services and reserves to World Bank; and 3% will subsidize privatized programs would be used as collerateral, under the scrutiny of the global observers. The funding of these installments are used to promote growth within Greece in order to create its foundation in the tax system to make it affective in the fiscal processing and politicians. What if Greece default again on its installments of the loan or the loan? The 3% of investment in the privatised programs will goes to China, and the parcel can settle on the prerformance after arbitration.

    It sounds naieve to accept such “Seven Percent Solution” when inflation rate is way higher than 7% in China, but what if Euro or its currency dropped over 7%. However, it is more important that the stand-off in the liabilities in both sides, then, rebalancing both the exchange rates or economies could make the situation worsen; then, not even the 3% is garanteed. If the slowdown of EU or US is contagious to the system, I doubt China can run on its 8% growth in the next year; but, the funding to the 7% coupon can stop Euro going with a run-off to 1.4 to 1.8 or RMB 4.5 to a dollar; or 15% write-off is demanded by the banking of China after default.

    “As a matter of fact, reward in the Hereafter (AAKHIRAT) should have been the main purpose of Islamisation. It might not have attracted many people, but the foundation would have been firm.” Islamic financing arrangements used in Islamic banking

    (MUSHARIKA, MURABIHA, QARDE AL'HASANA, IJAREH, MUDARABA)
    Author: EHSAN ZARROKH 2007-04-06

    I pondered how the Islamic finance can help if usury is not acceptable under the Sharia’h. If the IJARAH with 3% withheld by the World Bank, as insurers ‘tankaful’ using 1% in financing and supervising developments in "USUFRUKT", the privatized investment through agribusiness, or for the exchange of the coupon in deferred tax; then this Seven Percent solution can help to release the tension on the rollover sovereignty debts, and the debtor nation may not have to suffer further austerity program in shrinking its economy and restraining its growth. Some fantasy—but I like Islamic finance better than hoarding the currencies more for growth.

    May the Buddha bless you?

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