islamic banking and islamic capital market as it should be

ISLAMIC BANKING AND ISLAMIC CAPITAL MARKETAS IT SHOULD BE

By Prof. Dr. Iraj ToutounchianVisiting Professor

PRESENTED AT BANK NEGARA, MALAYSIA Nov. 24, 2009

1-Justification of the Workings of Islamic Banking as it should be:

WHY TO JUSTIFY? There have been attempts to show that there are many

similarities between Islamic banking and conventional banking, both despite the fundamental differences in philosophical foundations and non-existance of money market due to abolition of interest (Riba) in the Islamic Framework.

In capitalistic economy , the capital market is unduly overshadowed by the money market which, far from providing solutions to severe economic problems, impedes economic growth. In this system money has been placed in an “ivory tower” which has to be given its proper place.

My Study Shows that there are no similarities between the two systems at all. In the conventional system of zero-sum game, money is treated as private good. In my model money has been demonstrated to have the properties of impure public good; following Gordon Tullock’s assertion: Money, in and of itself, is an almost perfect expression of a large externality. Money then is judged by him to be a “public good”.

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WHY TO JUSTIFY? Zero rate of interest does not imply that Qarad-ul-

Hassan is the solution for all economic activities. There are Shariah-Compliant contracts that seem to be

sufficient instruments to finance needs of both individuals and firms. To be able to properly launch these contracts requires different skills to advise finance seekers as opposed to the conventional system where valuable collateral makes it easy to grant loan.

To substitute Islamic Contracts for interest-based loans in the conventional system will change the character and nature of the banks form monetary institutions to financial institutions. They, in turn, change the legal character of money to that of capital and hence making it eligible to claim profit.

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Rate of interest, money and more: As soon as money (i.e. potential capital) is legally combined

with other factors of production it changes to actual capital: M♀L → Actual Capital via the institution of firm,

(example: Mudarabah Contract) Money and/or debt market will disappear due to abolition of

interest. There are as many rates of interest as there are durable

goods. We can have wheat rate of interest, copper rate of interest, gold rate of interest, even steel plant rate of interest. (Keynes)

Keynes was the first economist to have discovered the root cause of the Great Depression by incorporating liquidity preference in his novel book, the General Theory

r → speculation → bubblesIt can also be shown that speculation →r > 0, based on Keynes’ assertion. 4


Rate of interest, money and more: Zero nominal rates of interest are necessary condition for

efficient resources allocation. (Friedman).

Later: Chocherlakota, et al:

Zero nominal rates are not only necessary but sufficient for efficient resource allocation.

Capital, in capitalistic system is artificially kept scare due to nominal rate of interest being positive (Keynes)

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THE ADVERSE EFFECT OF HOARDING

Wicksell: S+ΔM+DH=I

H ≡ Hoarding ≡ Liquidity preference ≡ speculation;

DH=Dishoarding=-H; H>0 If; ΔM=0 →S> I→ unemployment

Historical evidence: more than 1/3 of savings in USA goes to the money whirlpool and less than 2/3 goes to investment.

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UNIDENTIFIED SUPPLY OF MONEY

The investigation results obtained from the two appointed independent committees in US and UK show: due to problems faced as the result of speculative activities in the money market [money whirlpool], the supply of money cannot be defined. Further, if money is indefinable or includes a broad category of “assets” then monetary policy is impossible.

According to R. S. Sayers, one of the committee members: “The difficulty of identification has derived from the two-fold nature of money [in capitalism]… as a medium of exchange and as a store of value [being synonymous with hoarding and speculation]”.

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COOPERATION, JUSTICE, AND OPTIMALITY

Joan Robinson: the classical economists did not treat society as a cooperative.

Where the invisible hand fails to direct each person, mindful only of her own gain, to promote the benefit of all, cooperation provides a visible hand. (Gauthier)

The object of rational cooperative choice must be an optimal outcome….In non-cooperative interaction the core rationality property is equilibrium, whereas in cooperative interaction the core rationality property is optimality. (Gauthier)

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John Rawls: The circumstances of justice may be described as the normal condition under which human cooperation is both possible and necessary.

To most western economists, the concept of efficiency is based on Paretian value judgments which assume that: there is no “society” above and beyond the individuals. Thus one should be interested only in the welfare of individuals and nothing else.

This is an evidence for the fallacy of composition. Pareto optimality says nothing about justice. Nath: Pareto optimality is not necessarily superior to any

non-optimum.

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Cooperation

INCREASING- SUM GAME

Justice

Soci

ety

Pillars of Islamic economics: Ultimate Goal

Interaction between and among pillars give rise to increasing-sum game in an Islamic Economic System; the catalyst being social capital.10


Muslims feel bound to adhere to Islamic rules and injunctions because such rules, if carefully observed,, are for their own well-being and benefits, whether they are able to understand and analyze them or not. INTEGRATED MARKETS

We, here, attempt to avoid Neoclassical-Keynesian system to be dichotomized into independent real and monetary subsets. It is not, says Davidson, correct to separate monetary economics as has often been done; hence, integrating money in Capital theory as envisaged throughout the discussions made in my recent book. 11

THE OPERATION OF ISLAMIC BANKING

Schematic workings of two banking systems.

1. Advocate of Depositors

2. Partner of Investors

Islamic Bank

Financial Institution

As Share Holders

Depositors Investors 1. Borrower

2. Lender

Convt’l Bank

Monetary Institution

Lenders

Depositors Clients

Borrowers

FINANCE HOUSE LOAN HOUSE

Partners

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2. The Operation of Islamic banking:ITS ROLE IN INVESTMENT

To develop a model following simplifying assumptions are required.

All investment projects are financed by banks and in accordance with Musharakah PLS contracts.

Acting as agents (advocates) of the depositors, the banks use their customers’ deposits in any contracts signed but do not utilize their own funds.

Banks collect commission from depositors on any contract signed on the agreed terms and conditions.

As soon as PLS is signed all deposits are instantaneously legally transformed into capital.

There is a common fund pool (CFP) in the system and all depositors share in the prospects of all investment projects.

The depositors’ share of profits is generally proportional to the size and the time length of their respective deposits.

Depositors’ principal money is not guaranteed by the banks.

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2. The Operation of Islamic banking: ITS ROLE IN INVESTMENT

Assuming that (K) is the total capital needed to launch a project in PLS, (KF) is the firm’s share of capital, and (KB) is the bank’s share.

K= KB+ KF

Further, (∏) is the total profits, is the firm’s share, and is the bank’s share.

Under the condition of certainty, the expected profit E(∏) is the same as realized profits (∏). The bank’s relative share of profit to that of its investors (firms), , is :

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2. The Operation of Islamic banking:

ITS ROLE IN INVESTMENT

Altering the shares, (α), is found to be the most powerful financial policy tool for encouraging or discouraging potential investors (firms) to undertake new investments, or go with out it. Changing “α” does not imply market intervention. It is simply a ratio, not the price.Three distinct cases can be distinguished:

Case I In this case the overall economic policy of the Islamic state is such as to discourage potential investors.

Case II In which there is no preference by the government to go ahead or to go without the project; and

Case III Where the goal is to attract potential investors by offering them a profit share greater than their share in capital.

∏B/ KB <∏F/ KF

∏B/ KB >∏F/ KF

∏B/ KB =∏F/ KF

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2. The Operation of Islamic banking: its role in investment.

a- CERTAINTY CONDITIONAssuming output maximization and normal profit for entrepreneurs, the demand for investible funds (DI) can be written as:

It can further be assumed that the higher the depositors share of profit the greater would be the volume of deposits such that the supply of investible funds (SI) is:

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b- RISK CONDITION:

Using Private-Public Partnership(PPP) scheme. Having demonstrated that money, in the absence of

both interest (Riba) and speculation taking place in the money market, is an impure public good, the Islamic banks become state-owned banks and will be brought under public control. This is an approximation to the proposition made by Keynes.

Governments have to be looked upon as benevolent, big risk takers in risky conditions, and not as profit-maximizers.

Under the PPP scheme the state-owned bank’s share of profit must be reduced in order to compensate for the falling rate of expected profit to the investor, relative to its own share of capital.

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2. The Operation of Islamic banking: its role in investment. b- RISK CONDITION

The hypothesized equation with its positive derivatives with respect to risk, is the most important treatment of risk problem because it would certainly make prospects for private investment expenditure much brighter. In so doing, the government will actually assume the duties expected of it because it cannot behave as a profit-maximizing agent.Under the PPP scheme the aggregate demand for investible funds (DI) in the presence of risk can be written as:

Demand and supply for investable funds in an Islamic Economy (risk condition) 18


b- RISK CONDITION.Investors are assumed to be risk averters; that is for them to accept a higher risk, their expected rate of return must increase in the way stated below :

Equilibrium attained in an Islamic Economy (risk condition)19


b-RISK CONDITION.

Suppose for some reason the level of risk increases from σ1 to σ2

The risk conditions that have been initially and later caused by the government’s overall actions will induce the government to supply more funds for investment.This would shift the supply curve in the lower panel from (S1) and (S`1).To compensate for the higher risk, the banks’ share of profit relative to that of investors has to be reduced. To Propose a higher rate of profit to potential investors would certainly induce them to increase their demand for investible funds.By using PPP Scheme Islamic Banking offers a solution to this problem, something which that capitalist system has not been able to do, either theoretically or in practice.To liberate capital, capital needs to assume its proper role, as is the policy in an Islamic economy.

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3- ISLAMIC BANKING IS PRACTICALLY PART OF THE ISLAMIC CAPITAL MARKET.

FURTHER REFINEMENT

To follow the diversified policy of Islamic banking for financing Investment projects, the Islamic Bank offers another option to risk-averse Muslim households.

Take, for example, a situation in which a risk-averse depositor is faced with two stocks with different means and different standard deviations (risks) in their returns.

The covariance (Cov.) of the two stocks, x and y, is

Where

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If Px represents the proportion of income spent on stock “x”, then we should have:

(Portfolio)P = Px + Py

We know that the variance of the portfolio (P) is:

If we assume, for simplicity that the real returns of these two stocks are perfectly correlated,

Then:

Finally: 22

FURTHER REFINEMENT


This means that if a risk averse depositor decides to buy stock x whose risk (σ) is 15, he will put his savings in an Islamic Bank which uses the deposits in the two firms (x and y), where the standard deviation is less than the purchase of one stock.

In general, because Islamic banks diversify their risk through financing hundreds of investment projects, this reduces the weighted average risk for individual households investing their savings in one specific project or stock. Therefore, Islamic banking becomes more attractive to Muslim households than primary markets.

The risk-averse household can thus choose to put its savings into a CDA (common deposit account), rather than transacting on the Islamic stock market. In this way, Islamic banking promotes the “real” capital market without having to engage in the money market.

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FURTHER REFINEMENT

More Complex Issues 4- SPECULATION IS THE MAJOR CAUSE OF INFLATION.

Inflation theories have failed to provide answer to the underlying factors causing inflation. They all, one way or another, refer to excess demand (ED) but when looked for the answer as to: where and how ED emerges, the literature is silent.

Based upon our findings, we have come to the conclusion that speculation (the first derivative of interest) is the root cause of inflation. That is, the income received by all speculators on all durable commodities which are predominantly rich will change the pattern of the distribution of income and wealth.

The income-wealth dominance of the rich is never without economic consequences. Without doubt, the distribution of income (and wealth) has a real impact on general price levels.

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More Complex Issues4- SPECULATION IS THE MAJOR CAUSE OF INFLATION.

To illustrate this point, imagine a society with three income groups: high, middle, and low, whose demand for a specific commodity is D(1),D(2), and D(3), respectively. It can easily be shown that the total price elasticity of these three income groups, e, is not simple the sum of the three elasticities; that is:

More Complex Issues4- SPECULATION IS THE MAJOR CAUSE OF INFLATION.

We conclude that

This is interesting result because it means that the higher the share of the market in the hands of the rich, the lower would be the total price elasticity of demand and the higher would be the chance for upward pressure on the general price level.

The message here is that in order to have a sound economy the more equitable the distribution of income and wealth should be.

More Complex Issues 4- SPECULATION IS THE MAJOR CAUSED OF INFLATION.

Example: Recent statistical evidences show that American have more than triple the debt they had in 1982, and less than half the savings. Further, Gini coefficient of wealth is more than 82.

Result: If another country with the same population and the same

endowments could be found but with better equitable distribution of income and wealth the inflation rate in the latter country would undoubtedly be lower.

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5- Summary and Conclusions: With abolition of Riba (interest) and speculation as its first derivative:

1. Islamic banks become financial institutions,

2. No money and/or debt market is needed,

3. Outstanding feature of Islamic banking system is such that:

based on the availability of factors of production

Which in turn implies money is an endogenous variable, as opposed to:

in capitalism with the exception that investment is inversely related to the rate of interest.

It also best characterizes the capitalistic system making money supply an exogenous variable.

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ΔQ ΔM

ΔQΔMDue to

Δr

5- Summary and Conclusions:4. The connotation and implication here for endogenity of money

is basically different from those advocated by Post-Keynesian economists. This concept which was first perceived by econometricians divided them between horizontalists and structuralists (or structuralists versus accomodationists) where LM curve becomes flat. Their point of departure is whether rate of interest comes first or credit.

5. Opportunity cost of Capital becomes zero due to:

i.e. all investment projects are, one way or another, interdependent. Either investment is undertaken or not; (to be or not to be). In short, they compete with each other, meaning that cut-off rate is positive.

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5- Summary and Conclusions:In the simplest case where there are N investment projects there will be (N-1) cut-off rates but zero cost of capital. However in case of opportunity cost, in capitalism, there are N cut-off rates; rate of interest being one of them. Rate of interest plays two roles, one as the sole opportunity cost of capital for all projects and cut-off rate.

Assuming there are only three prospective projects open to a potential investor. He uses project (1) up to the scale (OT), but any further capital investment in this project can compete with project (2) of size larger than (OT) since any further expansion of output would reduce the rate of profit on this project. The third project would more profitable than project (2) of any scale larger than (OY).

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5- Summary and Conclusions:

Cut-off rate cannot be used as opportunity cost. In case of capitalism due to:

rate of interest is both cost of capital and used as cut-off rate. Furthermore, investment (I) defined to be change in stock of capital, (ΔK), in and of itself, is an evidence that: I ≠ g(r) despite the common view to the contrary.

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5- Summary and Conclusions:6. Primary market is endorsed but the stock prices have to be asset-

based in the secondary market,

7. Money becomes an endogenous variable implying that as far as there are factors of production available money supply can be increased. In other words, money supply is demand-determined as opposed to the conventional system in which money supply is an exogenous variable. We share the same terminology, i.e. “endogeneity” of money which is widely used in capitalism but very different in both meaning and implication in an Islamic framework. As long as markets (money and real) are segmented and kept independent from each other we cannot have endogenous money supply.

8. Required reserve ratio (RRR) can safely be reduced down to zero due to endogenity of money. Fractional reserve applies to interest-based banking system where supply of money is an exogenous variable.

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5- Summary and Conclusions:9. Corollaries to above conclusions are;

a) In the absence of interest (Riba) money has to be integrated in capital theory.

b) The model presented here puts an end to the scarcity of capital, which maintains full employment via S=I.

c) Islamic Banking becomes an integral part of Islamic Capital Market.

d) Treating central bank as natural monopolist the seigniorage can be brought down to zero which produces the general price level less than otherwise.

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5- Summary and Conclusions:e) The Islamic central bank need not act as an independent institution

(as it is in the conventional system). In order to make money an endogenous variable through its integration in the real sector, it makes sense that the institution responsible for financial policy is also part of the institution responsible for fiscal policy.

f) All in all, if Islamic banking, as an integral part of Islamic economics, is properly launched in its true sense, the results, cet. par., would be:

Stable general price level Full employment Equitable distribution of income and wealth Steady economic growth Counter-cyclical movements. Endogeneity of money in an Islamic setting will give rise to automatic

built-in stabilizer with the end result of a happy life for mankind.

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Thank you

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islamic banking and islamic capital market as it should be

Documents

system money

workings of islamic

islamic contracts

model money

islamic capital marketas

conventional banking

islamic framework

legal character of money