See History of Islamic Finance for a historical context.

Islamic finance is finance based on trade transactions in order to remove the basis of making money from money, often interpreted as interest. The trade transaction will typically involve an underlying asset. As such Islamic banks do not lend money, they enter into trade transactions based on leasing, partnerships and trading.

Based on Article by Dr. Sami Al-Suwailem, Head, Financial Products Development Centre, Islamic Development Bank.

Essence of Islamic Finance

At its heart, Islamic finance is a moral system of finance. It emphasizes the balance between for-profit activities, or the market, and not-for-profit activities, including social and philanthropic activities.

No economy can enjoy sustainable prosperity without the two domains in healthy equilibrium. Just as a bird cannot fly smoothly without the two wings properly functioning in tandem, an economy cannot “fly” without the two domains properly operating and serving the common good of the society.

It is a universal fact that no economy today nor in history has been able to rely solely on either of the two domains, to satisfy all its economic needs. What Islamic finance offers is a clear depiction of the boundaries between the two: market and non-market activities. The vagueness and instability of the limits to each sector lies behind the swinging movements in the past decades from over-regulation and big governments, to de-regulation and limited governments, and back again to re-regulation and over-indebted government. Unfortunately, the costs of these swings are so huge to citizens and countries, as have been realized in the global financial crisis, that we simply cannot afford this kind of experimentation. A stable and clear account of the boundaries between market and non-market domains can save humanity and world economy substantial costs.

With this background, we can look into two of the main tenets of Islamic finance.

Zakat

Zakat is an obligatory charity that has to be paid once a year. Among other things, a charge of 2.5% on idle balance of money has to be donated to the poor and the needy annually. Zakat represents the minimum philanthropic activity required from every able member of the community. Beyond zakat, however, philanthropic activities are strongly encouraged by the Quran.

Zakat is an effective measure against hoarding, which the Quran profoundly condemns as a major sin (9:34). Economists are well aware of the ills of hoarding. A person might benefit from hoarding his or her cash as long as others are spending. But if everyone hoards, the economy would collapse. This is known as “fallacy of composition,” whereby what works for an individual would be harmful to the community as a whole. Such fallacies are not rare in economics, and many, including J.M. Keynes, have pointed out to the “paradox of thrift”.

Zakat and other philanthropic activities are essential for market economies to counter-act the natural tendencies for increasing returns. “The rich gets richer” tends to be the norm rather than the exception in complex social systems, and it happens naturally rather than deliberately. But if this trend continues uninterrupted, extreme wealth concentration will cause economic stagnation as the majority of the community will have very little to spend. The solution lies in the non-profit sector. Philanthropic activities are essential, therefore, to attenuate and counter-balance this tendency.

 

The Islamic approach towards the negative side-effects of the market, therefore, is not to reject the market mechanism altogether, as with extreme communism. Nor is it to expect the market, in one way or another, to solve its own problems, as with extreme capitalism. “A problem cannot be solved at the level it was created”, Albert Einstein reportedly suggested long time ago. Instead, market’s side effects are remedied by moving to a higher level, that of the non-profit domain. In this manner, the two domains are properly balanced without hindering the normal functioning of either.

Riba

Throughout history, interest on loans or usury (riba) has been subjected to various forms of regulations and restrictions. All divine religions strictly prohibit taking interest on loans. A loan in an Islamic economy is viewed as a non-profit activity: it might possibly create wealth to the borrower, but not to the lender. Transforming a loan into a for-profit activity, via charging interest, leads to serious drawbacks.

The most damaging of such drawbacks is that it allows for exponential growth of debt irrespective of real wealth, creating what is known as the “inverted debt pyramid”. An inverted debt pyramid arises when huge layers of debt must be serviced by a shrinking base of wealth and income. Since growth rate of debt exceeds that of wealth, the system is not sustainable, and a correction must take place. Usually, correction happens through crashes and depressions, whereby excess debt burdens (as they become bad debts) are written off. This would restore normal debt levels relative to real wealth. But as long as the interest mechanism is at work, debt will start growing again at a rate faster than that of wealth, leading to another inverted debt pyramid, calling for yet another correction, after which the whole cycle is started all over gain. The system becomes “inherently unstable” as economist Hyman Minsky (1982) rightly describes it. According to economist Herman Daly (1996):

Since wealth cannot continually grow as fast as debt, the one-to-one relation between the two will at some point in time be broken—there must be some repudiation or cancellation of debt. The positive feedback of compound interest must be offset by counter acting forces of debt repudiation, such as inflation, bankruptcy, or confiscatory taxation, all of which breed violence. Conventional wisdom considers the latter processes pathological, but accepts compound interest as normal. Logic demands, however, that we either constrain compound interest, or accept as normal and necessary one or more of the counteracting mechanisms of debt repudiation (p. 179).

Nature of Interest

Interest is perceived by many as the price of money or value of time. This is not accurate. Interest is a mechanism for self-replication of debt. An interest of x% means that outstanding balance of debt will grow at x%. Since this growth takes place irrespective of wealth and economic activities, interest reflects the rate of divergence of financial obligations from real wealth.

As it became obvious after the financial crisis, debt has grown to unprecedented levels relative to the economy. Total debt in the US grew by 112% in 1998-2007, from $23 trillion to $48 trillion. In contrast, nominal GDP grew by only 56%, from $9 trillion to $14.2 trillion during the same period (www.federalreserve.org). That is, debt has been growing at a rate twice as that of the GDP. Derivatives, which are mainly financial obligations without any underlying real asset ownership, grew in the US from $33 trillion in notional value in 1998 to $165 trillion in 2007, with growth rate of 400% (www.occ.gov). It is obvious that the financial sector has been growing at rates much higher than the real economy.

For many developing countries, debt services exceed 60% of their exports. African countries pay for debt services almost twice as much as they spend on health care for their citizens. Debt is becoming a serious burden on the economy, not a means for growth and prosperity.

Authorities widely agree that debt must be constrained to avoid economic collapse. The European Union requires that member countries restrict government debt to less than 60% of their respective GDP, and that any budget deficit be less than 3% of GDP.

In economic theory, dynamic optimization requires satisfying the inter-temporal budget constraint (IBC); that is, spending shall be bounded by available revenue or income. Any interim borrowing must be repaid within the planning horizon. IBC excludes the possibility of “Ponzi financing”: that an agent borrows to pay interest on past due debt (Blanchard and Fischer, 1989). This requires that, in the long run, the present value of debt vanishes, which is a necessary condition for optimal dynamic behaviour.

Thus, in theory as well as in reality, debt must be controlled, or else the economy might collapse under exponential debt burden. But if the financial system is based on interest-based lending, controlling debt becomes a formidable task. It is not surprising, therefore, that all Divine religions have prohibited usury.

Integrated Finance

But Islamic finance does not stop at this point. Prohibiting interest on loans, as such, does not solve the financial needs of the society. 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 is derived from the integration of for-profit financing with real economic activities. This can be achieved through a large number of financial instruments, including 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 debt, and both include a financing 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 US (2002-2007), the majority of subprime mortgages, more than 70%, were used for refinancing (Demyanyk and Hemert, 2008).

In a mark-up sale, in contrast, debt is created solely for the purchase of goods or services. It integrates debt creation with real transactions that are the engine for wealth creation. Hence, debt is structurally imbedded in productive activities, and thus is used to serve the economy rather than the other way around. In this manner, time-value and debt replication are structurally disconnected: 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.

Of course, mark-up sale can be abused so that it is used to obtain cash rather than to own goods and services. In this case, there will be no economic difference between a mark-up sale and an interest-based loan, except that it becomes less efficient and more cumbersome to borrow. But this is against the objective of Islamic Shari’ah. The two most prominent Islamic Fiqh Academies in the Muslim world have ruled that organized transformation of mark-up sale to become a source of cash financing (organized and reverse tawarruq), is not Shari’ah compliant.

Finance is a Means

Nobel laureate Joseph Stiglitz (2009) points out that finance is a means for economic growth and prosperity. But when debt and financial commitments grow beyond the real economy, finance becomes an end rather than a means. “Finance had become an end in itself rather than a means to an end,” as Stiglitz rightly states.

By integrating debt creation with wealth creation, Islamic finance assures that finance is always serving economic activities, not the other way around. This integration prevents the creation of an inverted debt pyramid and thus prevents recurrent financial instability. Naturally, any economy will be exposed to cycles, peaks and troughs. But cycles arising from financial instability are much more severe and costly than those arising from real, natural causes, as has been confirmed by series of studies by the IMF (2008, 2009). As an elaboration, in 2008 stock markets lost $30+ trillions, while properties lost another $30+ trillions, according to World Bank chief economist Justin Lin, (www.abc.net.au; 04.02.2009). In contrast, insured catastrophe losses (earthquakes, tsunamis, man-made disasters including 9/11), were only $745 billion for the entire period of 1970-2007 (www.swissre.com; 17.02.2009).

At times when the world is suffering the burst of the “largest credit bubble in history”, as Nobel laureate Paul Krugman (2009) describes it, Islamic finance would have many insights that can guide the reform of world financial system. One example is the decision taken by German Minister of Finance, Wolfgang Schäuble, to ban naked short-selling – selling securities without either owning or borrowing them – in Eurozone sovereign bonds and credit default swaps as well as in the shares of 10 leading German financial stocks. The move, according to Financial Times, was in line with the minister’s thinking about the “danger of disconnection between financial transactions and real economic activity” (FT, 19.05.2010).

“A market does not function properly if the risks and rewards are completely unbalanced,” Schäuble says. “We must regulate over-the-counter transactions, and we must also focus on the ratio of financial transactions to the real exchange of goods and services. They bear no relationship to each other. I understand that we need new financial instruments to cope with the huge financial tasks that we face. But, forgive my saying so, minimum profits of 25 per cent are simply unimaginable in the real economy. It isn’t healthy.”

A Universal Cause

President of the European Central Bank, Jean-Claude Trichet (2009), calls for a “paradigm change for the global financial system”. With globalized markets, a global system of moral and ethical values needs to be in place to restore trust in financial markets. The essential principles of Islamic finance are not specific to the Islamic faith. They are shared by all Divine religions, and many worldly beliefs as well. The advancement of these universal values, therefore, serves the common goal of policy makers worldwide: to reform financial systems to the better of mankind.

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References

Blanchard, O., and S. Fischer (1989) Lectures on Macroeconomics, MIT Press
Daly, H. (1996) Beyond Growth: The Economics of Sustainable Development, Beacon Press.
Demyanyk, Y. and O. Hemert (2008) “Understanding the Subprime Mortgage Crisis,” Federal Reserve Bank of St. Louis, Table 1.
IMF (2008) World Economic Outlook, October.
IMF (2009) World Economic Outlook, April and October.
Krugman, Paul (2009) “How Did Economists Get So Wrong?” New York Times, Sep. 2.
Minsky, Hyman (1982) Can “It” happen Again? M.E. Sharpe.
Stiglitz, Joseph (2009) quoted in Emerging Markets, World Bank/IMF Annual Meeting, October, Day 4, p. 3.
Trichet, Jean-Claude (2009) “A Paradigm Change for the Global Financial System,” speech given at the International Colloquium roundtable, Paris, www.ecb.int.

*Article written by Dr. Sami Al-Suwailem, Head, Financial Products Development Center, IDB. The views expressed in this article are that of the author and not necessarily those of the Islamic Development Bank.

Source: Islamic Development Bank