The credit crunch has sponsored much discussion on the need for a new approach to banking and finance. While the Islamic financial system has been mentioned as a possible alternative in this regard, it is widely recognised that this system has itself been largely modelled on its interest-based counterpart. Both share the same material goals and adopt the same institutional structures, with the result that the products promoted by the Islamic finance industry are often indistinguishable from those of interest-based institutions. In an Islamic mortgage, the home-owner is in debt to the finance company just as he would be in an interest-based mortgage. Should he fail to make payments when due, the home-owner faces the same threat of repossession and negative equity that clients in the interest-based sector face. In the sukuk market, corporations are funded at financing rates that are specified at the outset of a transaction, just as in the interest-based bond market. Meanwhile, the practice of tawarruq allows Islamic banks to provide their clients with interest-bearing loans in all but name, through an elaborate combination of commodity trades.
These similarities have led some insiders to concede that the Islamic banking and finance industry has failed to properly implement the ideals upon which it was founded more than thirty years ago. They fear that a gradual merger between Islamic and interest-based finance is taking place, encouraged by commercial and political factors. Others wonder how such a vital function of Muslim society can be founded upon contractual devices that so many of its scholars reject, the enforceability of a promise being a particularly widespread case in point.
A serious and nimble response to these concerns is often hindered by a lack of intellectual honesty within the Islamic finance industry itself. Platforms are rarely provided to scholars who wish to take one step back and question some of the fundamental concepts that are being applied. Few questions are raised regarding the validity of Islamic debt financing, limited liability structures, speculative methods of market trading, or the nature of the monetary system. Such matters are given little attention in the headlong rush to copy interest-based methodologies and this has resulted in a number of embarrassing paradoxes. For example, while some Islamic investment managers attempt to develop Shari`ah compliant short-selling techniques, several western authorities are banning the practice on account of the instability that it causes. Most serious of all is the fact that, having copied the western template of finance, the Muslim world is in no position to point to a viable alternative at this time of crisis. In a few short months, thirty years of strategy have been debunked, and our industry leaders are left with little to say.
All of this is something of a tragedy, for a financial crisis of the present kind would not be experienced if the requirements of Shari`ah were properly implemented. Take for example the issue of risk-sharing. If commercial banks were required to share the profits and losses of their clients, whether on business investments or home purchases, they would be much more careful when choosing which deals to finance. This is because their financial returns would depend on the performance of the projects that they finance. Interest-based lending secured by collateral substantially divorces bankers from their clients’ risks, and causes heavy conflicts of interest. In many cases, the banker who signs a loan deal has already collected his bonus and retired by the time the deal goes bad. Interest-based finance also biases the provision of funds to those who are already rich. People with good ideas but no collateral (in other words, poor people) often fail to attract finance under this system, with the result that wealth inequality increases from one generation to the next. Risk-sharing finance does away with such conflicts and brings greater stability to economic activity. If the value of a bank’s liabilities was determined by the performance of its assets, there would be no sub-prime crisis now.
Unfortunately, risk-sharing techniques do not predominate in the world of modern finance. In fact the intention is often the opposite. Entrepreneurs and bankers like to increase risk, and then insulate themselves from it, in order to increase their return on capital. By borrowing from a bank at 5% interest and then investing in a business that makes 20% profit, the entrepreneur takes away 15 pence in profit for every pound invested. Commercial logic encourages such entrepreneurs to borrow heavily and grow their business operations. One consequence of this approach is that a few large organisations have come to dominate the business landscape. The heavy indebtedness of such corporations means that a moderate rise in interest rates combined with a moderate fall in revenues can quickly erode an entire profit margin. This is one reason that share prices can change so dramatically over relatively short periods. Furthermore, interest charges on bank finance are a cost item in the production process and therefore act to increase the price of goods and services. The interest payments that society receives from the banking system are therefore funded by society itself.
Another factor that leads to increased market volatility is the facility that exists for buying shares on deferred payment terms, or for selling them on deferred delivery terms. The result can be sudden swings in price as large numbers of sellers or buyers appear in the market, as if from nowhere. Under Shari`ah, ownership of a share is a pre-condition for its sale. Hence, there can only be one seller for each share at any one time. Secondly, the use of margin trading and forward trading is heavily restricted under Shari`ah. In other words, when trading shares, one or both countervalues (shares or cash) must be exchanged in full on the spot. By the application of these two rules alone, speculative forces are substantially reduced in financial markets.
The most powerful destabilising factor of all in modern markets is the activity of money creation by the banking system. By creating money out of nothing and lending it into circulation, central banks and commercial banks have together caused a succession of speculative bubbles that can be traced back more than three hundred years in the western world. When newly created money is spent on assets such as property and shares, their prices naturally tend to rise. Conversely, when banks reduce the rate of money creation, buyers disappear from markets and prices begin to fall. The ability to create money is therefore a hugely powerful political and economic tool, and one that is almost always abused in due course.
For this reason, Muslim thinkers such as Mahathir Mohamad have promoted the use of gold and silver as legal tender in place of ‘representative’ forms of money such as paper and electronic data. Unlike representative money, gold and silver cannot be created out of nothing. Under the precious metal monetary system, no organisation has the power to create money without cost, and this is one important guarantee of stability in the monetary system. We find that two Islamic regulations in particular work to prevent money creation by the banking system. These are the law of trust and the prohibition of interest. By issuing ‘promises to repay’ that are in excess of their cash reserves, and by lending these promises at interest, modern banks have contravened both of these regulations in order to earn profit.
If Islamic finance has indeed copied the methodology of interest-based finance, why are some commentators pointing to it as an example of stability during the credit crunch? Firstly, the Islamic finance industry is relatively small compared to its conventional counterpart, and the problems that it is experiencing can therefore be resolved mostly in private. Secondly, Islamic investment funds avoid investing in the shares of companies that are heavily indebted with interest-based loans (the shares of such companies have naturally performed better than those of companies that are heavily burdened by debt). Thirdly, the Gulf banking system is awash with the inflows of cash that have resulted from the high oil prices of recent years and this has so far insulated them from the liquidity problems that are being suffered by western banks. Only the second of these factors reflects a core difference of principle between the worlds of Islamic and interest-based finance, and this we applaud.
The current crisis has clearly been used to justify the re-capitalisation of the western banking system, but has there been anything deliberate in it? Even in today’s world, there are few ways of obtaining a trillion dollars of new capital in just a few weeks, and we remain unconvinced by recent events and the public narrative surrounding them. What is clear to us is that much of the cost of saving the banking system will be paid by those who have been so hopelessly indebted by it. However, a part of that cost will also be paid by those who have provided loan finance to the western economies in recent years. In due course, it is almost certain that the huge amounts of new money created as part of the ‘bail-out’ will lead to high inflation. The real value of western debt will be reduced at the expense of those who presently hold it, notably institutions in Asia and the Gulf. The US administration may regard this as a means of giving life to an economy that is suffering under the strain of wars in Iraq and Afghanistan, but it is unlikely to halt the gradual flow of economic power to the east. In the meantime, those who wish to protect themselves from financial manipulation should remember that precious metals have been a better long term store of value than representative money throughout history.
In our opinion, much of the Islamic banking and finance industry is a soft version of the secular system that we have described above, and it will therefore suffer from the same systemic problems. The proof that Islamic banks do not genuinely engage in risk-sharing will be that defaulting clients of Islamic banks suffer the same consequences as clients of interest-based banks. The proof that Islamic banks engage in money creation will be that the ‘Islamised’ economies of the Muslim world suffer the same inflation and boom-bust cycle that is evident in the west.
We call for a reconsideration of the objectives, institutional frameworks and contractual methodologies of the modern Islamic banking and finance industry. This effort must encompass the full range of technical and scholarly opinion, and it must have sincere political support. Some may argue that our scholars have indeed consulted with technical specialists when formulating their positions on these issues. We say that this is not so. The reality is that large global banks and a narrow selection of individuals have been allowed to set the agenda for the scholarly community. It is true that every journey begins with a single step, but in this case our first steps have taken us in the wrong direction. We are being led along the same road that defeated the usury prohibition in Christendom, and far from being part of the solution, our industry may soon become part of the problem. The Muslim world can do better than this. We have the solution that everyone is asking for, and what we need now is to truly believe that.
Haitham al-Haddad and Tarek el-Diwany