Reviving the roots of Islamic economics & finance. Rice University

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1 Reviving the roots of Islamic economics & finance Mahmoud Amin El-Gamal Rice University

2 Muslims mental image of Islamic finance Qur an and Sunnah Ijma c (consensus) and Qiyas (analogy) Islamic Economists istihsan (juristic preference), istislah (benefit analysis), c urf (custom), writings? Fiqh (Islamic jurisprudence) Ideal PLS contracts: Mudaraba (silent partnership). Musharaka (partnership), Short-term substitutes (credit financing): Murabaha (cost plus sales; usually with credit), Ijara (leasing), Forbidden conventional financial tools as Ribawi loan-based Suggest ideal alternative on left Pasadena: June 16, 2001 Mahmoud A. El-Gamal 2 out of 22

3 The role of Islamic economists Influenced jurist perceptions of the 4 (instigating factor) and (wisdom/ objective) of certain prohibitions e.g. myths regarding the prohibition of Riba fixed rate of return what about leasing and credit sales? return without risk what about credit risks and others? exploitation of the poor is still possible. In fact, it appears that the prohibitions of Riba and Gharar are built-in in prudential financial regulations Prohibition of Riba enforces marking to market ; ; see Prohibition of Gharar enforces optimal risk-sharing ;; see Convinced jurists that there is a viable radical Islamic alternative (e.g. various types of Islamic bonds via Ijara, Mudaraba,, etc.) Frustrated the attempts of practitioners Pasadena: June 16, 2001 Mahmoud A. El-Gamal 3 out of 22

4 Case study: Government bonds (a form of money) Solicited fatwas clearly illustrate banker and government disagreement with jurist views Jurist views are self-contradictory: Claim that fiat money is not a commodity, while commodifying it by analogy to gold & silver (various OIC FA decisions) Treat different currencies as different genera (KFH fatwa #164), but do not permit issuance of multiple monies with different seignorage (contrary to bi- metallic standard) Frequent use of,, and excessive classification of modern instruments under known contract forms Pasadena: June 16, 2001 Mahmoud A. El-Gamal 4 out of 22

5 Some interesting solicited Fatwas I Kuwait Finance House fatwa # 361: exchange or redemption of bonds in a different currency; forbidden Rajhi decision # 12: how can Rajhi help with the fiscal deficit; opinion listed suggested alternatives from Islamic financial engineering literature Rajhi decision #101: Platinum exempt from gold & silver exchange ( ( ) requirements! Pasadena: June 16, 2001 Mahmoud A. El-Gamal 5 out of 22

6 Fatwas II: Fiqh Acadmy 6/11/ following joint conference with IRTI and Moroccan Awqaf Ministry: Positive coupon bonds are forbidden ribawi loans,, regardless of labels Zero-coupon bonds are also forbidden since they are loans sold at a discount Bonds that pay [unpromised[ unpromised] ] prizes are also forbidden as loans that benefit the lender Recommend bonds that are tied to specific projects through PLS Mudaraba Pasadena: June 16, 2001 Mahmoud A. El-Gamal 6 out of 22

7 Fatwas III The late Sheikh Dr. Mustafa Al-Zarqa Zarqa opinion on Treasury Bills (2000) A treasury-bill cannot be classified except as an interest bearing loan to the government, regardless of labels All other bonds have the same loan status Major contemporary jurists are in consensus that interest = riba + reference to Dr. Chapra s book on a Just Monetary System Scathing attack on Dr. Tantawi s fatwa that raised doubts about his knowledge and faith recommends Musharaka and Mudaraba Pasadena: June 16, 2001 Mahmoud A. El-Gamal 7 out of 22

8 Economists & jurists I Jurists have adopted the worst traits of Economists: Treating new inventions (e.g. money, c.f. Goethe s Faust) like known historical entities Seeking temporary solutions to permanent problems, then defending them stubbornly Economists have adopted the worst traits of jurists: Legalistic form over function thought Absolutism in the definition of Islamic Pasadena: June 16, 2001 Mahmoud A. El-Gamal 8 out of 22

9 Paradoxes in Islamic Finance Rift between Islamic economic/financial system writings and the practice of Islamic finance (the supposed PLS ideals?) Highly segmented Islamic finance markets A small number of active jurists in the Islamic finance industry Jurists permit contracts, and then criticize their over-usage instead of the PLS ideal Pasadena: June 16, 2001 Mahmoud A. El-Gamal 9 out of 22

10 Equity ( ) Ethical/Islamic Jurist Preferences ( 4 / &4 ) Juristic-Islamic Permissibility Frontier Secular/Banker preferences Different Financial technologies Efficiency ( Model to explain paradoxes Pasadena: June 16, 2001 Mahmoud A. El-Gamal 10 out of 22

11 Equity ( ) The need for an Islamic Economics and Finance Evolved Financial technology Efficiency ( Pasadena: June 16, 2001 Mahmoud A. El-Gamal 11 out of 22

12 Equity ( ) Islamic Economics ideal Common Choices Modern Islamic Finance (closest permissible point) Where do we go from here? Social development-oriented community Islamic Finance Efficiency ( Pasadena: June 16, 2001 Mahmoud A. El-Gamal 12 out of 22

13 Equity ( ) How far to innovate? 0: perfectly safe 1: extreme innovation Efficiency ( Pasadena: June 16, 2001 Mahmoud A. El-Gamal 13 out of 22

14 Model: basic components Credibility(x)=1-B(x α,λ); α=π n; λ=(1- π)n-1; e.g. π= jurists Profits Credibility jurists jurists Degree of innovation Profit(x)=x Credibility(x) Pasadena: June 16, 2001 Mahmoud A. El-Gamal 14 out of 22

15 Competition Given one bank s s level of innovation, second bank can: 1. Share monopoly profits, 2. Innovate further, or Challenge: : discredit first bank to take his business 3. Challenge Innovator s s profits: (1 F( x )) π (, ) ( )(1 ( )) x1 x2 = x2 + x1 x2 F x1 2 F( x1) F( x2) Conservative s s profits: π ( x, x ) = x (1 F( x2)) 2 F( x ) F( x ) 1 2 Solve for Cournot-Nash equilibrium (fixed point) Pasadena: June 16, 2001 Mahmoud A. El-Gamal 15 out of 22

16 The Economics of Jurisprudence Degree of innovation Innovator's innovation Cons ervative 's innovation Monoopolist's innovation Profits Innovator's profits Conservative'sprofits 1/2 Monopolist's profits Number of jurists Number of jurists Pasadena: June 16, 2001 Mahmoud A. El-Gamal 16 out of 22

17 Explaining the paradoxes As more jurists get involved: At first, the industry sees more conservatism Then, beyond some point, more innovation Despite the rhetoric, banks benefit from jurist-supported supported market segmentation If jurists cared only about perceived & : quit at minimum innovation (proximity to conventional finance) Pasadena: June 16, 2001 Mahmoud A. El-Gamal 17 out of 22

18 Outstanding questions Can we recognize as probable what is now treated as a certainty (virtual consensus)? Can we overcome outdated suspicions of western economics and financial products? Can we overcome the urge to come to hasty conclusions regarding the understanding of the Islamic Legal Texts? Can we be more careful and less apologetic for historical jurisprudence based on outdated thought Pasadena: June 16, 2001 Mahmoud A. El-Gamal 18 out of 22

19 Opportunity: Islamic & conventional banking convergence? 90 Assets and liabilities decomposition for U.S. commercial banks 80 Deposits as a percentage of total liabilities Non-real estate loans as a percentage of total assets Jan70 Jan75 Jan80 Jan85 Jan90 Jan95 Jan00 Jan05 Source: Federal Reserve Statistical Release H.8, Feb. 2, 2001 Pasadena: June 16, 2001 Mahmoud A. El-Gamal 19 out of 22

20 Opportunity: Islamic & conventional banking convergence? 90 Income and expense decomposition for U.S. commercial banks Gross interest income as a percentage of total income Gross interest expense as a percentage of total expense Source: Federal Reserve Bulletin, June 2000 Pasadena: June 16, 2001 Mahmoud A. El-Gamal 20 out of 22

21 Opportunity: Islamic & conventional banking convergence? 60 Net non-interest income as a percentage of gross income of commercial banks Belgium Canada France Germany Luxembourg Switzerland U.K. U.S.A Source: Bank Profitability: Financial Statements of Banks, OECD, Pasadena: June 16, 2001 Mahmoud A. El-Gamal 21 out of 22

22 Economists & Jurists II Can jurists adopt the best traits of economists Be skeptical about their models ; recall that all human-judgment judgment-based knowledge is wrong Consult with the best in the business, rather than the closest in ideology/rhetoric Can economists adopt the best traits of jurists Think about function rather than form & label Consider overall social costs and benefits, rather than champion political/ideological causes Pasadena: June 16, 2001 Mahmoud A. El-Gamal 22 out of 22

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