The Problem in Islamic Finance

Today's fake fatwa actually deals with real fatwas. If that doesn't make you head hurt, nothing will.

Anyway, Islamic finance is a topic I've been thinking about a bit for some time. However, since I'm not a Muslim or Shariah scholar, I've always felt like this was one of those things where you run the risk of being an outsider offering unwanted opinions on something you know nothing about. (Does Arabic have a word for "kibitz"?) Nonetheless, I'm heartened by an article in last week's Financial Times by Muhammad Saleem, an investment banker and author of Islamic Banking: A $300 billion Deception. (See Islamic finance has much to learn from the west).

When most Americans think of Islamic finance or Islamic banking, they probably think of terrorist financing. This is wrong, of course. Terrorist financing has as much in common with Islamic finance as money laundering has in common with "traditional" banking. Though, as a general matter, any time you mix religion and finance, the results usually do not have pleasant connotations. For example, even today "Jewish banking" brings to mind conspiracy theories and pograms. How about "Catholic banking" -- indulgences and albino monks, anyone? Or "Evangelical Christian finance." Can't you just see Tammy Faye's mascara-running tears and Jim crying about hookers? Let's just say there's probably a reason Jesus drove the money-changers from the Temple.

But Islamic finance actually is something that is different from the type of financing that has developed in the West over the past 500 years -- at least in theory. And it is beginning to be big business. There are two reasons for this, I believe. The first is oil money, of course. With the price of oil being what it is, many Muslim countries are flush with cash, and it's hardly surprising that they have put a great deal of this cash into Islamic financial institutions. But this isn't the whole story. After all, these countries were flush with cash in the 1970s as well, but Islamic banking really didn't take off in any real sense until the 1990s. So some of the growth of Islamic finance, I believe, might be fallout related to Samuel Huntington's "clash of civilizations" idea. At a time of great uncertainty and conflict, when Muslims and Westerners think of each other as "us versus them," we humans have a tendency to seek solace with tradition. One way to do that is to seek out new "old ways" of doing things that allow us to reinforce our cultural and religious identities while offering alternatives to the very things that seem most foreign, uncertain and hostile. And I think, for some Muslims, Islamic banking might fall into this category.

Islamic finance has several characteristics that make it quite different -- at least on the surface -- from "traditional" Western finance. The most obvious is the prohibition on earning interest. But there are others as well. The Koranic injunction against gambling has been interpreted as a prohibition on contracts where the final terms of the contract (the thing to be delivered, how much is to be paid, etc.) cannot be determined until some future event. This interpretation effectively prohibits most Western commodities and futures contracts and insurance. There is also a third prong to Islamic finance that goes to what you can invest in, rather than the form the investment may take. This, however, is relatively straight-forward and very similar to Western concepts of "ethical investing." For example, following Islamic investing principles, because Shariah prohibits eating pork, drinking alcohol, gambling and watching pornography, investing in Hormel, Seagrams, PartyGaming and Playboy would be no-no's.

The first point -- the prohibition on earning interest -- is not unique to Islam, of course. The Old Testament (particularly Exodus 22:25-27, Leviticus 25:35-37, Deuteronomy 23:19-20, Psalm 15:5, et al.) all prohibit charging interest, in one form or fashion. (Exodus and Leviticus seem to prohibit it only if one is lending to the poor; Deuteronomy prohibits it in loans given out to fellow Jews/Israelites, but allows it when lending to foreigners.) Throughout most of Christian history, the Old Testament prohibition was adopted in canonical law, with charging interest to fellow Christians considered a sin and "usurers" ineligible to partake in the Eucharist.

This historic distaste for charging interest was not limited to the religious. Aristotle, in both the Politics and the Ethics argues that charging interest is wrong. In the Politics, Aristotle describes usury as:

The most hated sort (of wealth generation) and with the greatest reason, is usury, which makes a gain out of money itself and not from the natural object of it. For money was intended to be used in exchange but not to increase at interest. And this term interest, which means the birth of money from money is applied to the breeding of money because the offspring resembles the parent. Wherefore of all modes of getting wealth, this is the most unnatural.

It wasn't until the Protestant reformer John Calvin came along that the West rejected this view (though even Calvin thought charging interest was wrong if the borrower was poor). (By the way, I'm not a particularly big fan of Calvin, but I am very thankful it was his economic views, and not Martin Luther's, that came to dominate post-Reformation Europe.)

Islam, however, has yet to have its John Calvin. The result is that much of modern interpretation of the Koran runs directly contrary to modern financial concepts -- particularly the concepts of the time value of money and risk. For example, most Shariah scholars argue that interest is impermissible, while profit-sharing is acceptable. The idea is that a guaranteed return on an investment is wrong because the risk is not shared equally between the lender and borrower if misfortune should occur; however, if the risk is shared equally, the "lender" and "borrower" are partners and the arrangement is just. Put simply, equity investments are fine, but bonds are not.

For this reason, much of Islamic finance involves creating mechanisms that replicate the benefits of bank lending, but have the appearance of profit-sharing or buying and selling. For example, with a typical "traditional" car loan, the bank lends you money, at a certain interest rate, for you to purchase your car. If you default on the loan, the bank takes your car, sells it, and collects what it is owed and gives you whatever may be left. With an Islamic "loan," the bank buys the car and then sells it to you at a mark-up, to be paid in installments over time. You end up paying the same amount under both scenarios. However, Shariah scholars believe the Islamic loan is more just because, if you default, the bank simply takes back the car and has no further claim on you. With a traditional loan, the bank may still pursue you for any remaining principal if the repo doesn't provide enough.

(As an aside, there was a case a few years ago where a woman unknowingly bought a stolen car using an Islamic bank. She lost the car after a fender-bender brought to light that the car was stolen, after which she refused to repay the loan, saying that the bank had sold her a stolen car. Much to the bank's chagrin, the Shariah scholar charged with adjudicating the case sided with the woman. The bank's representatives complained that they specialized in making loans, not buying cars and running title searches. The scholar replied that you are either lending at interest or selling at a mark-up -- you can't have it both ways.)

However, modern finance recognizes that debt and equity are just two ends of a very smooth risk continuum. This is particularly the case in the modern world were bankruptcy laws exist. As a practical matter, car loans are secured with little more than the car itself, whether the bank is Islamic or "traditional." One corrollary of Merton Miller's and Franco Modigliani's work is that the difference between debt and equity is risk, and in an efficient market, the risk-return ratio of debt and equity are the same. In other words, if the market is efficient (and things like taxes and subsidies of various sorts factored out), the less risk I take as a lender, the less return I can expect. Or, if I'm a borrower, the more risk I expose my lender to, the more I'm going to have to pay to get the lender to part with his or her money. The calculus is as close to an iron-clad law as you can get in economics. Consequently, if I'm an Islamic bank and I'm on the hook if your car ends up being stolen goods, or if the only thing that can secure the "loan" is the car itself, the borrower is going to end up paying more at the end of the day. Whether we call it interest or profit, paying more is paying more.

The car loan example described above (called a "murabahah" or "cost plus" transaction) is relatively simple. Other types of financial transactions designed to replicate insurance products, futures contracts, and various financial hedging strategies are considerably more complicated and far less transparent. Indeed, many Islamic bond structures (sukuk), Islamic insurance (takaful), and Islamic futures contracts involve a degree of complexity and opacity that rivals those used by Enron. (Islamic insurance can even involve a certain degree of willful fiction: when a policyholder suffers a loss, the insurance fund doesn't contractually compensate the policyholder; rather, the other policyholders "donate" to help the misfortunate. Presumably, reneging on this "donation" is frowned upon.)

This, fundamentally, is the problem I have with Islamic finance as it is most commonly used. It uses very complicated structures to accomplish the exact same goal as Western finance, but with added cost and opacity. It is, as Rice University professor Mahmoud Amin El-Gamal has called it, a case of Muslim customers "paying more for less." In this sense, I believe Islamic finance today shares much in common with Christian finance of the Middle Ages, particularly after the traditional Jewish financiers were exiled. (Following the Deuteronomy passage noted above, many Jews at that time believed lending at interest was permissible, provided the borrower was not Jewish. Since Christians had the same prohibition where the borrower was Christian, Jews often became the preferred financiers for Christian enterprises, up to and including lending money to finance the construction of Christian monasteries and the First Crusade.) When Edward I in 1275 banished 15,000 Jews from England, lending money at interest did not disappear -- it merely went underground, to the detriment of borrower and lender alike. David Hume, in his second volume of the History of England writes:

...as it is impossible for a nation to subsist without lenders of money, and none will lend without a compensation, the practise of usury, as it was then called, was thenceforth exercised by the English themselves upon their fellow citizens, or by Lombards [Medieval Italian pawnbrokers] and other foreigners. It is very much to be questioned whether the dealings of these new usurers were equally open and unexceptionable with those of the old. By a law of Richard it was enacted that three copies should be made of every bond given to a Jew; one to be put into the hands of a public magistrate, another into those of a man of credit, and a third to remain with the Jew himself.

But as the canon law, seconded by the municipal, permitted no Christian to take interest, all transactions of this kind must, after the banishment of the Jews, have become more secret and clandestine; and the lender, of consequence, be paid both for the use of his money and for the infamy and danger which he incurred by lending it.

Hume wrote this in the mid-1700s, and while the situation today is somewhat different with Islamic finance, the end result is the same. In short, the predominant interpretation of the Koran today makes it more expensive for poor and middle-class Muslims to borrow money and buy insurance. It makes them less secure in their retirement, because it increases the transaction costs and lowers the returns on their pension funds. And I believe that this is fundamentally opposed to the objective of the original Koranic injunction.

This, of course, is where I am on a bit of thin ice. I have had Muslim colleagues quite logically argue that human reason is limited and if God comes up to you and tells you not to do something, you don't ask for an explanation for His reasons. However, I still believe context is important. (Ironically, for this I must thank my Muslim colleagues' predecessors. If it weren't for Averroës and other Muslim scholars, the West would have never rediscovered Aristotle. And without Aristotle, there would have been no Thomas Aquinas and the philosophy that the will of God can be deduced from both Scripture and reason.)

For example, Sura 2:275 of the Koran (using the Penguin Classics translation -- unfortunately, I cannot read Arabic) states:

Those that live on usury shall rise up before God like men whom Satan has demented by his touch; for they claim that trading is no different from usury. But God has permitted trading and made usury unlawful.

This is as pretty clear a prohibition as you can get. But if you read the immediately preceeding passages, you see the context:

To be charitable in public is good, but to give alms to the poor in private is better and will atone for some of your sins. God has knowledge of your actions...Those that give alms by day and by night, in private and in public, shall be rewarded by their Lord. They shall have nothing to fear or regret. (Sura 2:271, 274)

Likewise, Sura 3:130 states:

Believers, do not live on usury, doubling your wealth many times over. Have fear of God, that you may prosper.

But following this passage, the Koran says:

Obey God and the Apostle that you may find mercy. Vie with each other to earn the forgiveness of your Lord and a Paradise as vast as heaven and earth, prepared for the righteous: those who give alms alike in prosperity and in adversity; who curb their anger and forgive their fellow men (God loves the charitable); ... (Sura 3:132-133)

Viewed this way, it appears that the prohibition against interest is closely tied to protecting the poor from abuse. In this sense, these Suras are very similar to several of the Old Testament passages noted above:

If you lend money to one of my people among you who is needy, do not be like a moneylender; charge him no interest. (Exodus 22:24)

If one of your countrymen becomes poor and is unable to support himself among you, help him as you would an alien or a temporary resident, so he can continue to live among you. Do not take interest of any kind from him, but fear your God so that your countryman may continue to live among you. You must not lend him money at interest or sell him food at a profit. (Leviticus 25:35-37)

In each of these cases, the prohibition on charging interest is couched in the language of charity and protecting the poor. When we consider that the bankruptcy protection -- the idea that debts can be discharged by a court if the debtor is impoverished and unable to repay the debt -- is a relatively new idea, the prohibition on usury where the poor are concerned makes sense. After all, the historical fate of a defaulting borrower was debtors' prison or worse. But bankruptcy laws change the risk calculus. All lenders today are "partners" in the sense that repayment is never guaranteed. What varies is the risk the lender takes, and the return the borrower offers. Where a free, liquid market exists, risk correlates with return, to the benefit of both borrower and lender.

The same situation exists with regard to Islamic insurance and futures contracts. Shariah law prohibits gambling, and while the Koran does not spell out the reasons for this prohibition, the moral issues that attach to gambling are well known. Gambling does not create wealth, but merely moves it from one person's pocket to another's, based on chance. It can be addictive, and a gambler's losses can not only affect the gambler, but also that gambler's family and others for whom he or she is responsible.

But chance and risk are two entirely different things. While it is certainly true that some financial speculators might as well be gambling, insurance products and futures contracts inherently are the opposite of gambling. They are about controlling and limiting risk, not profiting from chance. Consequently, Shariah scholars who interpret the Koran as equating most traditional insurance products, futures contracts, and hedging transactions with gambling are missing the point of the original Koranic injunction. If the objective is to protect the poor and generate social good, few things have contributed more to this over the past 300 years than our understanding of risk. (By the way, a really good book on this subject is Peter L. Bernstein's Against the Gods: The Remarkable Story of Risk.) The complex and opaque mechanisms used by Islamic finance to achieve precisely the same risk management that is provided by cheaper and more transparent traditional methods is a disservice to those Muslims most in need. It is hard to imagine that this was the Prophet Muhammad's objective.

There are other problematic issues with Islamic finance that Muhammad Saleem and Professor Gamal discuss, particularly those relating to the Shariah scholars hired by Islamic financial institutions to opine on whether a given investment or financial product is permissible. These scholars are hired and paid by the financial institutions themselves and, absent some kind of branding mechanism, it is easy to see that this presents a classic conflict of interest. (You can be sure that Islamic financial institutions know which Shariah scholars are sticklers, and which take a more laid-back approach to interpreting Shariah; and I imagine the latter tend to have a better employment record.) But this problem is one that can probably be addressed through regulation and market mechanisms (i.e., disclosure and branding). The bigger issues relating to the interpretation of what constitutes "usury" and "gambling" may not.

So what are the alternatives? I think the first is to return to first principles. In this regard, I believe Professor Gamal's mutualization ideas may be very valuable. Gamal argues that it is not the form of financing that is problematic under Shariah principles, but the profit motive. Therefore, financing organizations such as mutual savings and loans and mutual insurance companies, where borrowers are also shareholders in the bank or insurance company, may still be perfectly acceptable even if they charge fixed interest or use traditional insurance contracts, because they are non-profits and the benefits are shared by all members. Personally, I suspect that such banks will be less economically efficient than for-profit banks, but they likely will still be an improvement over existing Islamic financial institutions and mutualization will address certain social justice concerns. Such institutions will also be far more transparent, given that they will operate under existing banking and insurance regulatory systems.

Another approach might be for Shariah scholars (and Muslims generally) to focus on those financial activities that are similar to the types of abuses that the Prophet Muhammad was concerned about. This would be a true social justice approach to Islamic finance. For example, does the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 unduly harm the poor? Does the U.S. student loan system, which features government-backed loans, the near impossibility of discharging the loans regardless of economic circumstance, and high fees charged by the private institutions that provide these loans at no risk to themselves, have elements of the usury that the Koran decries? Or so-called "payday loans," often used by the poor despite exceedingly high interest rates and very low risk to lenders? Do these practices harm the poor to the benefit of the powerful? If so, Shariah scholars (and all Muslims, and Jews and Christians) all have a role in pointing this out. However, the current approach of most Islamic finance that focuses on mere form rather than substance does not provide a viable alternative to these abuses, and adds to the problems that the Prophet Muhammad sought to alleviate.