A Potential Model for Islamic Microfinance III: Proof of Concept Experiments

I have been working closely with two graduate students, Mohamed El-Komi at UT-Dallas, and Adam Osman at Yale, on the first phases of testing the proposed model of microfinance with zero interest along the equilibrium path. Dean Karlan, of Yale, may become more involved in the project going forward, especially if we proceed to implementation of a field experiment and impact study -- something that he's worked on in other parts of the world.

We received funding from the Kelly Day Foundation at the James A. Baker III Institute for Public Policy, where I have recently begun to serve as a fellow, and started working late summer 2009. In Fall 2009, Mohamed, Adam, and I went to Cairo and began to assemble the local research team; and then Mohamed and Adam went with the research team and ran some pilot experiments in two villages north and south of Cairo (attempts to run pilot experiments in Manshiyat Nasser, a Cairo slum, were discouraged by the locals). In January 2010, they went back and ran extensive "experiments in the field" and we have just begun to analyze the data.

I have added Mohamed and Adam as blog authors. Over the coming days and weeks, we should be posting the model designs that we used (one Grameen-style, and one based on RoSCAs), and showing some basic data summaries and analysis. We also hope to post some of our discussions of potential implementations here. One discouraging point has been the bankers' lack of interest in microfinance (I met some high-level bankers in Egypt last summer, and their notion of microlending was L.E. 5,000 to L.E. 50,000 loans, approx. $1,000 to $10,000, on which they bragged that they make positive returns!). However, to implement the RoSCA design, we cannot simply partner with NGOs. The Post Office, which is the recipient of most micro and small deposits in the country, may be a better partner, but we'll have to wait and see.

At any rate, we shall soon begin a series of posts on the experiments, our thoughts about them, and possible next steps.

The Economist article on European mutuals

This week's Economist magazine has a nice article on financial mutuals or cooperatives (where the shareholders are the same as the depositors), and their merits during financial market turmoil. In particular, they highlight the inherent risk-management benefits of not having separate shareholders on whose behalf the manager may try to take excessive risk with the depositors' money (they can only lose their capital, and the profit potential is unlimited). The article also talks about how mutuals-of-mutuals have emerged in Europe, to replace partially the need for central banks as lenders of last resort or other ways to bail out failed banks. In my earlier papers and my book on Islamic finance, I have echoed those well known arguments for the benefits of mutuality, and shown that one reading of Islamic jurisprudence is that the forbidden elements of riba are eliminated in the case of mutuals. See three articles of mine on this topic here 1, here 2, and here 3.

Justification and the four-step vicious circle of "Islamic finance"

I payed attention to "Islamic banking" when it first appeared in Egypt during my college years (1979-82), then again starting in the mid 1990s, and much more vigorously starting in 1998 when I took the "Chair in Islamic Economics, Finance and Management" at Rice University. In all those years, I have observed participants in this industry go (in circular fashion) through four main steps:

1. Utopianism: Driven by ideological, religious, and social concerns, they seek economic and social answer in the vague financial commands of the Qur'an and Sunnah (the Qur'an does not explicitly say what the forbidden riba is, and doesn't mention gharar, the Sunnah gives some examples of forbidden riba and gharar, but not sufficiently to give unequivocal definitions thereof). We trust the "Scholars" (back in the late 70s and early 80s Egypt, that included household-name scholars such as Al-Sha`rawi, Al-Qaradawi, and most accomplished Azhari scholars).
2. Engagement: As consumers, practitioners, or consultants, the Utopians start to engage the industry, either directly or through closer observation.
3. Disenchantment: The engaged Utopians discover that the practice of Islamic banking and finance does not go beyond replicating what was already there, at ridiculously higher interest rates (for example, here in the U.S., "Islamic" auto-loan structures in the 1980s were offered at 22 to 25%, when the going market rates were below 10%.) They become disenchanted. Some disengage, but others remain engaged for one of two reasons: (i) residual Utopianism and dreams of eventually changing the industry through continued engagement (the "young industry" fallacy), or (ii) their livelihood as bankers, lawyers, consultants, etc., has become entangled with the industry, the have become used to higher incomes and living standards and recognize that they have been shut out of the conventional sector because of their "Islamic" identity.
4. Justification: Those still engaged in the industry pick up the hobby of themselves criticizing the industry that they have participated in creating (it started with some bankers and lawyers, but now even "Shari`a scholars" who are the second-largest financial beneficiaries after lawyers, and who legitimized the industry by leveraging religious-legal authority, including Taqi Usmani and others, have joined the fray). A new narrative emerges, about the need for a different benchmark to replace LIBOR, new structures that are closer to the "Islamic ideal," etc. Those assertions help to shape a new Utopian vision of "true Islamic finance," which revives Utopianism (if cynical) within the engaged community (serving thus as justification for their continued engagement) and attracts a new wave of Utopians, leading back to step 1.

Those, like myself, who have decided to disengage and say that the entire enterprise is incoherent, are deemed "controversial." Recently, a very smart young man was seeking my advice on getting an advanced degree in Islamic finance and joining the industry. I told him that as it stands, all justifications in step 4. notwithstanding, engagement with the industry can only lead to one of two outcomes: (i) co-option and corruption if one remains engaged and perpetually engaged through incoherent justifications, or (ii) frustration, demoralization, and eventual disengagement.

Neither is a good outcome. So, for all fresh-minted Utopians out there: Keep your distance, and keep Utopian dreams where they belong.

UNEPFI Membership: Will Islamic Finance turn to positive injunctions?

Michael Gassner pointed out to me his call for institutions engaged in Islamic finance to jointhe United Nations Environment Programme's Finance Initiative. This initiative aims to"promote linkages between sustainability and financial performance."

This is consistent with my earlier call in my book on Islamic Finance that those engaged in Islamic finance should support the earlier UN initiative for financial markets knows as "who cares wins."

I have long been a critic of the Islamic finance industry focusing mainly on avoiding prohibitions, but not recognizing that prohibitions are secondary to positive injunctions:

إن الله يأمر بالعدل و الإحسان و إيتاء ذي القربى و ينهى عن الفحشاء و المنكر و البغي، يعظكم لعلكم تذكرون

"God commands justice, beautiful dealings, and generosity to one's kin, and forbids ugly dealings, blameworthy behavior, and transgression; he admonishes you, so that you may remember."

For instance, why are "Shari`a compliance" screens for stock investment simply negative in nature (avoiding certain types of stocks based on ratios that are often questionable religiously and economically, but that is another subject) and letting fund managers decide based on purely financial risk-return tradeoffs within the allowed universe of securities. It would make more sense for an "Islamic" portfolio to also balance how much good a company does in deciding how much weight to give it in an investment portfolio.

I second Michael Gassner's call, and hope that the trend toward more positive aspects in "Islamic finance" will eventually justify the name (rather than simply focusing on how to make people excessively indebted or otherwise mimic conventional financial players in ways that utilize medieval legal tricks).

Panel discussion on Al-Jazeera TV

I participated in this panel discussion on Al-Jazeera TV on Tuesday. I found what the other panelists said to be outrageous: Islamic bankers do not seek profit? We have a lot to teach the West? Conspiracy theories?... how could they say this stuff with a straight face? I guess they were pandering to a particular Arabic-speaking audience rather than trying to state the truth as they see it. If that is the case, then it is a tragedy. If they truly believed what they said, then that is an even greater tragedy:

إن كنت تدري، فتلك مصيبة ... و إن كنت لا تدري، فالمصيبة أعظم

Have we learned nothing? Here come the "Islamic Credit Default Swaps"

Mohammed Khnifer, Islamic Banking Senior Editor at Al-Eqtisadiah and Al-Masrifiah Islamic Banking Magazine, pointed out this new development to me.

In a recent article, it is reported that the end of the year 2009 was punctuated with 10 defaults on "Islamic Sukuk" (otherwise known as poorly designed bonds), and then suggested that the "experts" want Credit Default Swaps to protect investors against the risk of default on Sukuk!! Here's a translated excerpt:

A group of informed experts on the Islamic finance industry called for a "partnership" between Islamic takaful (insurance) industry and Sukuk, toward the end of assisting the latter in providing "protection" for investors against losing their funds that they invested in these Islamic instruments.

Those calls became louder after the recent registration of the Pakistani cement company Maple Leaf as the last company with defaults on its Rupis 8 billion Islamic bonds.

The experts suggested during their interview with "Al-Iqtisadiya" that Takaful companies should find a new insurance instrument for Sukuk, which can protect the Sukuk holders from the risk of default, by providing "partial" compensation in the case of default.

This only months after the conventional CDS industry nearly brought down the entire international financial system.

"Islamic finance" started with a suggestion that the "Islamic economics" philosophy rests on sharing in profits and losses through partnership (i.e. equity) finance. In practice, of course, the industry moved toward debt finance, where the only risk is default risk. Now, they want to insure against credit risk as well, which is of course possible, but defeats the entire purpose.

You see, risk -- like matter -- can neither be created nor destroyed. Sharing in profits and losses provides for continuous risk sharing at moderate magnitudes. Debt financing provides for less frequent but larger losses in cases of default. Debt financing together with credit default swaps provides for very infrequent but catastrophic systemic collapse, which is very unlikely at any point in time, but highly likely to occur sometime within an extended period.

So, the most recent crisis has not taught the participants and experts of today's "Islamic finance" much (I use the quotation marks because they do Islam a great disservice by using it as a brandname to market their grossly inferior and poorly construed products for a profit). Will the customers at least finally see that this is not an infant industry that needs to grow?

Pain, not gloating

A number of people emailed to ask me why I haven't written blog entries in recent months.

The main reason is that most of the trouble that I have warned against in recent years, including about the faulty legal structures of so called sukuk as well as other debt instruments marketed as "Islamic" (see my 2006 book Islamic Finance: Law, Economics, and Practice, Chapter 6 on faulty sukuk structures), and the speculative bubbles that were again plaguing the Middle East (my 2009 book with Amy Jaffe -- an expert on energy markets -- Oil, Dollars, Debt, and Crises: The Global Curse of Black Gold), have come to pass. Contrary to what those who criticized me for my gloomy predictions may think, I had wished all along that I was wrong. When bad things happen, sincere people do not gloat: they feel too much pain to do that.

Therefore, I do not want to write to say "I told you so." I am, instead, starting to work on my next book project on Middle-East economic development. To the extent that the region's limited absorptive capacities have contributed to local bubbles and then global credit bubbles (1980s and again this decade), enhancing the region's real (i.e. industrial) growth prospects is in the region's as well as the world's long-term best interest. However, national-level industrial plans (as in Saudi Arabia, for instance) are too limited in scope.

My argument at recent conferences has been that we need an industrial plan at the regional level. Unfortunately, this type of plan would run contrary to the short-term profit motives that have fueled speculative bubbles, of which the debt culture that has been marketed as "Islamic finance," as well as closely-related debt-driven construction booms, are but two examples. Commissions that short-term rent seekers can collect in those two bubble industries prevent the region from focusing on the task ahead -- the last opportunity to use the region's mineral wealth as an engine for long-term industrialization.

Microfinance experience vs. credit union -- Grameen I

I am reading a good book that gives details on the institutional history, structure, and experience of Grameen and Grameen II. The book is Asif Dowla and Dipal Barua's The Poor Always Pay Back: The Grameen II Story, Kumarian Press, 2006. A number of interesting thoughts came to my mind, especially in relation to my thought of using RoSCA-JAK hybrid structures to generate credit unions organically using the existing institutions in Egypt. The notes in this post relate to Chapter 2 of Dowla and Barua's book, which focused on the original Grameen model and its evolution. Quotations from the book will be in quotation marks, followed by my comments/thoughts:

• Interestingly, Grameen itself has a mutual structure, with all members forced to save with the bank, and part of those savings are shares in the bank itself (on which, at least as of 2005, the shareholders did not receive dividends; they received 8.5% interest on their deposits). This begs the question why Grameen was not set up at the outset as a non-profit credit union (more on that later).
• One potential answer is the following: "A major reason for the prior failure of credit cooperatives in Bangladesh was that the groups were too big and consisted of people with varied economic backgrounds... more affluent members captured the organization" (p.18). This suggests, perhaps, that those cooperatives were structured more like mutual savings banks (one share = one vote) rather than credit unions, which are much more democratic in nature (one shareholder = one vote).
• Grameen used presaving to qualify for loans, which I did not know from reading secondary and tertiary sources: "To receive a loan, borrowers were required to save ... [in the form of] deposit[ing] a fixed amount weekly... [in addition to] a 5% deduction from the loan... [as a] group tax. The compulsory weekly savings and loan deductions were used to create a group fund, and the borrowers were paid 8.5% on their deposits." (p.19) This is somewhat reminiscent of JAK structure, except that interest was paid on deposits and charged on loans (mostly at 20% for general loans).
• Branches borrowed from the main office at 12% and lent at 20%, eventually covering their costs and making a profit after three to four years of operation. (p.30) Why is sustainability always associated with profitability? A nonprofit credit union can be more sustainable than a profit-maximizing bank.
• The structure is standard banking practice: the poor had to save and deposit with the bank, earning 8.5% on deposits and 0% on shares; then the bank lends funds at 12%, and the branches lend them on to the poor at 20%. The miracle of Grameen is that it was very successful in growing, mainly by providing credit to those whom the banks did not consider creditworthy or sufficiently lucrative. However, that is not nearly sufficient to suggest Grameen over a credit-union structure, where all deposits were shares earning dividends, and where loans are made at the lowest possible interest rate to avoid losses (without necessarily resorting to the weak argument that at least the interest rate is lower than what loan sharks would charge).

Microcredit and usury

Today's Wall Street Journal online has an interesting article about a microloan credit bubble. Is this not the very definition of usury:

Here in Ramanagaram, a silk-making city in southern India, Zahreen Taj noticed the change. Suddenly, in the shantytown where she lives, lots of people wanted to loan her money. She borrowed $125 to invest in her husband's vegetable cart. Then she borrowed more.

"I took from one bank to pay the previous one. And I did it again," says Ms. Taj, 46 years old. In four years, she took a total of four loans from two microlenders in progressively larger amounts -- two for $209, another for $293, and then $356.

At the height of her borrowing binge, she says, she bought a television set. The arrival of microfinance "increased our desires for things we didn't have," Ms. Taj says. "We all have dreams."

Today her house is bare except for a floor mat and a pile of kitchen utensils. By selling her TV, appliances and jewelry, she cut her debt to $94. That's equal to about a fourth of her annual income.

As with every other type of credit, when it can be extended for profit, the incentive to overfinancialize can be impossible to overcome. I have made the argument more than once, in part based on works in classical Islamic jurisprudence and legal theory, that profiting from the act of credit extension is the essence of forbidden usury/riba. The approach through non-profit mutuals, credit-union style, is vastly superior, and agrees with the spirit of early experiments in Islamic finance in Egypt and the Subcontinent.

Unfortunately, people's good intentions have been subverted in Islamic finance toward serving the interest of profit-maximizing multinational banks that have, de facto, rewritten modern Islamic jurisprudence to maximize their profitable arbitrage opportunities. Likewise, this article shows how the very essence of microfinance has been subverted by rent seekers to enrich themselves at the expense of the poor debtors (who may benefit briefly, but will ultimately suffer when the bubble bursts).

FT Op-Ed: Debt is capitalism’s dirty little secret

Ben Funnell wrote a great piece in Financial Times:

The answer is capitalism’s dirty little secret: excessive lending was the only way to maintain the living standards of the vast bulk of the population at a time when wealth was being concentrated in the hands of an elite.

The amount by which the elite has benefited is startling, and illustrates the problem with lightly regulated free markets: the rich get much richer while the rest do not get richer at all. According to Société Générale economists, the inflation-adjusted income of the highest-paid fifth of US earners has risen by 60 per cent since 1970, while it has fallen by more than 10 per cent for the rest. As was recently pointed out in the New York Review of Books, the Walton family, of Wal-Mart fame, is wealthier than the bottom third of the US population put together – about 100m people. These are staggering statistics, confirmed by measures such as the US and UK’s ever-rising Gini coefficients, which estimate income disparity. Another way of putting this is that the share of profits in gross domestic product is at a 100-year high, or was until very recently.

Put simply, the benefits of economic growth have gone into the pockets of plutocrats rather than the bulk of the population. So why has there been no revolution? Because there was a solution: debt. If you couldn’t earn it, you could borrow it.

Interview with Ash-Sharq Al-Awsat

This interview on Islamic finance is buried many links deep on the website.

Islam in America and the Clash of Exceptionalisms

This is the summary of a khutba (sermon) that I gave at ISGH Main Center on May 8, 2009. A number of people asked me to write it down, so here is a brief summary.

One of the traditional verses to start a sermon is [59:18]:

يَا أَيُّهَا الَّذِينَ آمَنُوا اتَّقُوا اللَّهَ وَلْتَنْظُرْ نَفْسٌ مَا قَدَّمَتْ لِغَدٍ وَاتَّقُوا اللَّهَ إِنَّ اللَّهَ خَبِيرٌ بِمَا تَعْمَلُونَ

The traditional translation is: "O ye who believe! Fear Allah, and let every soul look to what (provision) he has sent forth for the morrow. Yea, fear Allah: for Allah is well-acquainted with (all) that ye do." I would not limit the collective order اتَّقُوا, which is repeated twice in the plural, I would not limit it to "fear", because the notion of taqwa encompasses God-consciousness, God-wariness, and other concepts besides fear.

Our focus for today is on the following: the verse does not say "let every soul" or "let each soul" (و لتنظر كل نفس) but rather "let a soul" (و لتنظر نفس), focusing on the community of the faithful (addressed: يَا أَيُّهَا الَّذِينَ آمَنُوا) as a single organism. In other words, although we are accountable individually, we are also accountable for the future (مَا قَدَّمَتْ لِغَدٍ) that the community as a single organism forges for itself.

This notion of humanity as a single organism is also prevalent in the Qur'an. Verses [4:1], [6:98], [7:189], and [39:6] all proclaim that all mankind were created from a single soul, e.g. [4:1], another traditional introductory verse for sermons, states:

 يَا أَيُّهَا النَّاسُ اتَّقُوا رَبَّكُمُ الَّذِي خَلَقَكُمْ مِنْ نَفْسٍ وَاحِدَةٍ وَخَلَقَ مِنْهَا زَوْجَهَا وَبَثَّ مِنْهُمَا رِجَالا كَثِيرًا وَنِسَاءً وَاتَّقُوا اللَّهَ الَّذِي تَسَاءَلُونَ بِهِ وَالأَرْحَامَ إِنَّ اللَّهَ كَانَ عَلَيْكُمْ رَقِيبًا 

"O mankind, be wary of your Lord who created you from a single soul and created its spouse therefrom, and put forth from the pair many men and women, so be wary of God whom you ask for favors and be wary of your ties of kinship, verily God is ever watchful over you."

Therefore, depending on the context, one may think of all mankind as a single organism (created from a single soul), think of any given community as a single organism, and so on. Within the context of the community of faith, the Prophet (p) said (as narrated in Muslim): 

مثل المؤمنين في توادهم وتراحمهم وتعاطفهم مثل الجسد إذا ‏ ‏اشتكى ‏ ‏منه عضو تداعى له سائر الجسد بالسهر والحمى 

"The example of the faithful in their mutual empathy, mercy, and sympathy, is like the [single] body, when one organ complains [from injury] the rest of the organs empathize through sleeplessness and fever."

Let's take this metaphor of the body to address the recent affair of Houstonian Zubair Bouchikhi. He has been recently released on bond, but for many months, his case of incarceration was discussed in our mosques and gatherings. It is normal to feel and share the pain that he and his family have suffered, just as the Prophetic Saying suggests parts of the body should respond to one another with empathy. 

Taking the metaphor of the single body to the next level, let us ask: how did the rest of the body (our community) lead this part of the community (Zubair) to incarceration in the first place? It is easy to blame overzealous informants, whose numbers in our mosques have grown exponentially in recent years as part of this lucrative growth industry of xenophobia toward Islam and Muslims. We must also blame ourselves, however, for not understanding our home (America) and the difficult transformations that it has been undergoing in recent decades.

I touched some raw nerves a few years ago when I discussed this very issue. The anger that some of you felt at that time was a natural coping mechanism to being exposed to the fact that our story as Muslims in America (which we are authoring as we play the lead roles) is different from the story that many of us think that we're living. It is safer for me to do what I have done since then, which is to focus on mainstream Islamic teaching on the importance of perseverance, God-wariness, thankfulness for blessings, etc., which would not push anyone in the congregation out of their comfort zone, and you would all leave happy. 

However, this topic of American Islam is too important to leave unspoken. If there is to be an Islam in America 100 years from now, it must be an American Islam that fits comfortably in the fabric of American society. This requires abandoning the rhetoric that there is only one Islam, which is patently false, since Islam in Malaysia is different from Islam in Indonesia, Islam in Pakistan, in Saudi Arabia, in Egypt, etc. Each community evolved within its own historical and cultural context, and although they share some common factors, they are distinctly different. I will try to push you a bit out of your comfort zone of the Orthodoxy narrative, which we feel compelled to profess on the pulpit, in order to start the community thinking about those problems. I hope not to push you too far out of your comfort zone at this time.

First, we must understand our place in American history. As Abraham Lincoln pointed out sarcastically in his debate with Stephen Douglas in 1858, the founding fathers meant that "all [white Protestant] men were created equal." This was, and continues to be, an integral part of American exceptionalism. Of course, this exceptionalism has been fading over time: We elected a Catholic President in 1960 and a black President in 2008.

It is interesting that this transformation (the fading of American white Protestant exceptionalism), which accelerated with the civil rights movements, coincided in 1965 with removal of visa quotas and the ensuing latest (and perhaps final) wave of Muslim immigrants. Earlier waves (Muslim Moorish sailors on the Columbus crew, West-African slaves, 1920s auto workers brought from Lebanon and Palestine to work in Ford factories, etc.) were different. Those of us who came in the 1960s onwards were graduate students and professionals, who built Muslim Student Associations, Islamic organizations, mosques, etc. 

Because American exceptionalism was beginning to fade when we arrived, we did not feel compelled, as Jewish immigrants felt in the 19th Century, to create a reform movement that would integrate our Islam with the dominant Protestant Christianity that defined America in her earlier phases. We were given space to practice our religion as we had in our native countries, and we were even given space to profess the Orthodoxy of Islamic exceptionalism, which sustained some of the more myopic among us into thinking that Islam can survive in America without becoming an "American Islam."

The mass murders of September 11, 2001 may have been a catalytic transformative event, by bringing more law enforcement and intelligence informants into our mosques, but our problems - and the problem of Zubair - cannot be attributed to 9/11. After all, the mass murderers of 9/11 came from somewhere else, they were not home grown. European experiences suggested that home grown problems should also be a concern, but I would suggest that Zubair's problem has a different origin.

Zubair's problem was the following: Most of us do not live the Orthodoxy, nor do we profess it. We all have family members who are the equivalent of Jewish reformed, taking the occasional drink, maybe praying only on festivals and other occasions, etc. Most of us in the mosque are probably conservative: making all prayers, fasting, etc., but not adhering totally to the Orthodoxy as professed, say, in Saudi Arabia, and generally doubtful of the Islamist myth of the "ideal Islamic society". Of course, we also have our Orthodox, who do not wish to mix with the other sex or with other faiths, but they are a tiny minority, mostly composed of non-violent puritans (ultra Orthodox in the Jewish taxonomy). 

However, most of the conservative who come to the mosque regularly want the comfort of hearing the Orthodoxy professed from the pulpit. They lionized those who professed that Orthodoxy, albeit alien to their daily lives both temporally and spatially: The Orthodoxy does not represent who we are, and it does not even represent who the Saudis are -- it belongs to a mythical place in time and space. It is accommodated in our native societies as harmless narrative, but it scared the informants who are increasingly frequenting our mosques and who were not familiar with that narrative. They did not think that this rhetoric is harmless (and maybe for good reason, given the European and more recent American experiences of home-grown cells). They found it quite alarming. The parts of our community that lionized the profession of the Islamist exceptionalist Orthodoxy by Zubair and others is primarily responsible for his predicament.

When America listened and heard our profession of the Orthodoxy of Islamic exceptionalism, this awakened the worst and ugliest of America, the part that America had worked hard for two centuries to overcome: Islamic exceptionalism clashed with and awakened American exceptionalism. America has grown since the 1960s to accept diversity, until part of this diverse mosaic began to profess its own (transnational) exceptionalism, and this made it more difficult to envision Muslim Americans as an acceptable part of the American mosaic.

I promised not to push you any further away from the comfort zone of listening to the familiar Orthodoxy: familiar because we've heard it professed from our pulpits for decades, albeit alien to who we really are. Therefore, I will stop here. However, I beg you, for the sake of my grandchildren and yours, who are and will be fully American and Muslim. They are not only Muslim Americans, but also American Muslims, in the sense that they are culturally and politically different from Muslims native or immigrant to other parts of the world. Let's drop the anachronistic and alien Orthodox rhetoric, and replace it with a narrative that is consistent with who we are as American Muslims. This is the only way to have an Islam in America two generations from now: It has to become (institutionally) an American Islam that defies Islamic exceptionalism even as it defies American exceptionalism.

Parable of the Growth Tragedy

Everyone, from IMF officials to G20 leaders to the rest of the world, are obsessed with restarting economic growth: It is the only way out of poverty, we are told. It is the only way that we can be happy, they imply.

[Postscript: thanks to Michael Gassner for pointing me to the original reference for this story, authored by Heinrich Böll in 1963.]

This reminded me of a story that my professor in economic development told us nearly 30 years ago (I think that it was Galal Amin, but I am not sure; it does sound like him, though). The story goes as follows (with some license due to memory deficiencies and the desire to express some thoughts):

A man lived alone on his island. Every morning, he went out of his hut, jumped into the water, caught two fish, and then sat on the shore cooking and then eating them.

An entrepreneur watched the man for a while. Then, he approached the man, and said: "why don't you give me one of your two fish." The man said: "but I like to eat two fish, why should I give you one." The entrepreneur said: "if you give me one fish, I'll give you some of this green paper." The man said: "but I don't eat green paper, I only eat fish."

The entrepreneur said: "you don't understand: you work harder to catch 3 fish and give me one, then you sell me that extra fish and get some green paper, once you have accumulated enough green paper you can give it to me, and I will give you a fishing rod." The man said: "but I don't need a fishing rod, I can't eat it, and I can catch all the fish that I need without it."

The entrepreneur said: "but with a fishing rod, you can catch four fish with less work." The man said: "but I only eat two." The entrepreneur said: "So, you eat two and give me two, so that I can give you double the amount of green paper." The man said: "we've already been over this -- I don't eat green paper, I only eat fish." The entrepreneur said: "you're really slow -- when you've accumulated enough green paper, you can give them to me, and I'll give you a fishing boat."

The man said: "but I don't eat boats, I eat fish." The entrepreneur said: "with a boat, you will catch 8 fish a day with even less work." The main said: "but I only eat two." The entrepreneur said: "so, you eat two and give me six so that I may give you more green paper, and before you ask me any further, you will soon have enough green paper to have a fleet of fishing boats, and you can eat as much as you want without doing any work and just keep getting more green paper."

The man said: "maybe I am the slow one, but let me ask you this: would I not then be obsessed with useless green paper, lazy, fat, and possibly exploitative of my fishermen?" Then he added: "and with all those fishing boats, do I not run the risk of overfishing the sea to the point that we all starve in the long run?" In the meantime, "I am happy now, catching my two fish, staying fit, and having time for other things."

The entrepreneur left, thinking to himself: "I'll find somebody else who sees the brilliance of my idea, and you will someday work on one of his boats just to survive, as there will be no easy-to-catch fish readily available near the shore."

Crooks in the name of Islam

As I was thinking of a good name for the RoSCA management and insurance scheme that I wanted to propose for Islamic microfinance, I thought of the name بنك القرية (the village bank). I was extremely depressed when I googled that term, and ran across this article about embezzlement of funds. So, I stopped writing this string of posts. Then, yesterday, I was watching an Egyptian television show on Dream Channel, which covered another wave of شركات توظيف الأموال (fund mobilization companies, similar to the ones that were popular in the 1980s when real interest rates in Egypt became significantly negative). The show discussed a recent case with the wrinkle that marketing was done by the son of the Egyptian Minister of Economic Growth. We all know about the pyramid schemes in the 1980s under the same banner of "Islamic finance".

What is it about this industry that invites snake oil salesmen in religious garb?

Maybe it was a mistake even to contemplate doing research in this field. One should stay away from the snake oil salesmen lest one's reputation and religion be compromised.

A Potential Model for Islamic Microfinance II: Resisting The Banking Temptation

When developing an Islamic financial model, the temptation is very strong to try to mimic what bankers already know. Indeed, that has been the history of Islamic banking and finance: start with the conventional practice that you forbid but want to mimic (e.g. an interest-bearing loan), break it down into its pieces (e.g. money now from A to B, more money later from B to A), and then reconstruct the pieces with some degrees of separation (e.g. goods sold for money now from C to A, goods sold on credit for more money later from A to B, and goods sold for money now from B to C -- this is tawarruq if the bank conducts all three transactions, or commodity murabaha if the bank only does the first two pieces and leaves it up to B to make the spot sale to C or another party D). This is the silly model marketed variously as commodity murabaha or tawarruq (including red arrows formally):

A comment to the previous post mentioned the practice of "chit funds" in the Indian-Pakistani subcontinent, wherein participants in a RoSCA who have not yet collected the pot bid for the pot at each stage of the cycle. This adds an explicit interest rate (discount pricing, similar to the way Treasury Bills are sold) to the implicit one imposed only by the order of collection.

There are many other ways that one can explicitly add interest rates to the basic structure of a balanced RoSCA:

• Later rounds of the RoSCA, approved by jurists, as described in the previous posting, may be for larger pots. This gets around the problem of introducing interest payments within a single RoSCA cycle -- which is the focus both of commercial "chit funds" and much of the Economics literature (e.g. Besley, Coate, and Loury, American Economic Review, 2003). As I shall discuss below, I think that this focus on a single cycle of the RoSCA misses the main significance of investment in social capital: one is compelled to participate (as a later recipient) in a RoSCA when one is asked. Social capital is the availability of a pool of people willing to lend you at zero interest at some/any point in the future. One should focus on the repeated game rather than one stage.
• Participation in one or more RoSCA has been shown to increase with reported religiosity, as shown in Indonesias' participation in one or more arisan using probit and ordered probit estimation by Sowmya Varadharajan. This is very useful because an individual who cannot in one period fulfill their obligation in one RoSCA may start another of which they are the first recipient to meet liquidity problems. In other words, the social capital invested in one's circle of friends/family/... provides guaranty against default and dissolution of earlier RoSCAs. This can easily be used to manufacture banking products through staggered overlapping RoSCAs: the second recipient of the first RoSCA is simultaneously the first recipient of the second RoSCA, the third recipient is the first recipient of the third, and so on. This way, later recipients of the pot from earlier RoSCAs can receive explicit interest for the loans that they extended by receiving an interest free loan of equal or larger size. It would be very easy to mimic any amortization table using such structures (a simple spreadsheet would do).
• Unfortunately, the latter possibility makes these structures vulnerable to the creation of pyramid schemes. Indeed, in the different but related JAK system, it appears that a pyramid scheme did develop in the earlier experiment before the bank was licensed and regulated. There is an inherent pyramid scheme in every fractional reserve system (otherwise, what is the banking multiplier other than a pyramid scheme), and we have seen ample proof over the past few months to illustrate that our entire financial system is one gargantuan-sized pyramid scheme (as Krugman called it, the decade at Bernie's). Of course, one has to be particularly careful not to build  pyramid schemes in the name of Islamic finance, especially given recent decades' experiences in Egypt, Albania, and other countries (in addition to numerous unfortunate web-based pyramid schemes in Malaysia and elsewhere). However, that is a regulatory concern that extends well beyond the specific problem with which we are currently concerned.

So, it is clear that we can deform RoSCAs the way that Islamic finance lawyers and consultants have subverted classical Islamic contracts (e.g. structuring loans cynically through the trust sale known as murabaha, which was simply negotiation of a profit margin instead of the final price, trusting the seller to reveal their cost -- i.e. negotiating markup over invoice, without any credit sale component). However, this would defeat the purpose of trying to reboot Islamic finance. 

The idea is not to have as one's goal replication of the existing conventional finance. Indeed, my argument has been that if we can replicate a conventional practice, then we should use that replication as a form of juristic identification (تكييف فقهي), for example of mortgages, to permit the more efficient conventional practice in such cases. In cases where we or our target audience find a conventional practice to be forbidden Islamically, the objective should be to take an existing practice that is generally accepted by the Muslim public, and (credibly) approved by religious scholars who issued their opinions independently from institutions that make profits based on their religious opinions, and then to see if we can make the practice (e.g. RoSCAs) more efficient. In this quest, we should keep the structures as simple as possible, in order to avoid confusing religious scholars or potential customers.

My proposal (to discuss in the next post) is to organize the leveraging of social capital inherent in RoSCAs using a hybrid of the mutual banking structure of JAK (which is conducive to development into a credit union model) and the theory of takaful (literally: mutual cooperation, but the term is used for non-commutative forms of insurance marketed by Islamic finance providers, albeit not structured properly as mutual insurance).

A Potential Model for Islamic Microfinance I.5: RoSCA permissibility

In my previous posting, I referred to this article for a summary of juristic opinions in Saudi Arabia on the permissibility of Rotating Savings and Credit Associations known as gam`iya or jam`iya in most Arab countries. Here's a translation of this article:

Workers' Cooperative (جمعيات الموظفين)

Among the popular financial dealings between people is that known as "workers' cooperative." There are three main forms of such cooperatives as explained by Associate Professor Abdullah bin Abdulaziz Al-Jibrin in the Teachers' College in Riyadh:

1. A group of people agree each to pay the same amount each month. At prespecified periods, they take turns collecting the entire pot. A full round is finished when each member has collected the pot once. At each step, the payments are equal, and the pot is of the same  size. Thus, everyone pays the same and collects the same as everyone else. The cooperative may continue for two or more rounds if all parties wish it. Most often, the "banker" of the cooperative collects first followed by the next person to join the cooperative. Sometimes, a lottery determines who collects if all parties to the cooperative were equal. At other times, the one most in need collects first.
   
2. ...
3. Another variation would require that two or more rounds must be completed, with the order of collection changing from round to round so that the first borrower in the first round would be the final collector in the second, and so on.

... This is an old practice that has been addressed by classical scholars, including Abu Zar`a Al-Razi, who was one of the leading narrators of Prophetic Traditions, and he indicated that it is permissible, as stated by Dr. Khalid Al-Mashqih, a Saudi scholar.

Scholars' Rulings on the Practice

... Contemporary jurists have issued two opposite opinions:

1. One group of scholars forbid such cooperatives. This group includes Sh. Abdulaziz Al Sheikh the Mufti of the Kingdom of Saudi Arabia, Sh. Saleh Al-Fawzan, a Saudi scholar, and some members of the Saudi Council of Major Scholars
2. The majority (جمهور العلماء) opinion among contemporary scholars is permissibility of this practice. This was the opinion of the late Sh. Bin Baz, the late Sh. bin `Uthaymin, Sh. Muhammad Salih Al-Munajjid, Sh. ibn Jibrin, Dr. Abdulla Al-Faqih, and other scholars, including the majority of the Saudi Council of Major Scholars who thus adopted this majority opinion as its official position in opinion #164 dated 26/2/1410 H, during the 34th round presided upon by the late Sh. Abdulaziz bin Baz...

Grounds for disagreement

The reason for differences in opinion regarding this practice is how it is classified juristically. Some viewed it as a loan that is beneficial to the lender, and thus forbade it, and others saw it otherwise and permitted it.

The reason that some saw it as a beneficial loan is that participants extend a loan with a stipulated condition of another later loan, which is beneficial. Thus, those who adopted this position cited the Prophetic Traditions: "every loan that is beneficial to the lender is [forbidden] riba" and "if one of you makes a loan and then receives a gift or a favor to ride the borrower's animal, then he should neither ride nor accept the gift, unless such courtesy had occurred before" (reported by Ibn Majah).

Those who permitted the practice argued that the benefit that accrues to the lender does not result from any financial loss to the borrower. On the contrary, they argued, the benefits were mutual and virtually equal. Thus, both the lender and the borrower are beneficiaries, without any harm imposed on either party or any benefit at the expense of the other. In this regard, the benefit that is forbidden in loans is the type that accrues only to the lender. However, mutually beneficial loans that benefit both lender and borrower are permissible...

Those who permitted the practice also argued that the default ruling for financial transactions is permissibility. Therefore, prohibition requires proof, and there was no valid proof for prohibition in this case. On the contrary, they argued, this is classified under mutual assistance, good charity, and assistance of fellow Muslims.

In addition, the "proof" of prohibition is based on the Tradition "every beneficial loan is [forbidden] riba", which is a weak tradition with faulty chain of narration. The scholar of Tradition ibn Hajar said that its chain of narration is weak. In this regard, the weak tradition was admittedly accepted as a juristic rule, but not every benefit in a loan is deemed forbidden. The other tradition ostensibly presented as proof for forbidding the practice is categofically invalid, as Al-Haythami said in Al-Zawa'id: "it contains `Utba ibn Hamid Al-Dabi, whose narrations are rejected by Ahmad and Abu Hatim. 

Therefore, all proofs of prohibition are weak. In contrast, the proofs of the majority who permitted the practice is much stronger...

In this regard, the great scholar ibn Taymiya listed examples of permissible mutual benefit when he said: "There is no harm for a farmer to say to another: `help me to do my work and I will help you to do yours; you work with me today, and I work with you tomorrow'."

In summary, "financial cooperatives" (الجمعيات المالية) are permissible Islamically, and it is best to use collateral or guaranty (ضمانات) for participation, to minimize disputes, and to document the mutual debts for all participants in a manner that guarantees each party's rights. 

(My emphasis at the end, because this is rarely done in a systematic way: which is the opportunity for microfinancial improvement)

The Egyptian Dar Al-Ifta (opinion #5568) went further by arguing that such mutually useful practices are not only permissible, but commendable because mutual cooperation is one of the best religious works.

A Potential Model for Islamic Microfinance I: Introduction

I am embarking on a potential research program with established researchers in developing-country microfinance experiments (the research team of Dean Karlan). I am not sure if this research program will take off the ground (law enforcement logistics of doing anything in majority Muslim countries are often difficult). I gave a couple of presentations on the proposed structure, including in Abu Dhabi, hoping that somebody from ADIB would be there to give us feedback and possibly to facilitate the experimental study, but had no luck.

Part of my thinking was motivated by a senior thesis on which Mubeen Khumawala, a student at neighboring University of Houston, asked me to serve as external reader. I had known most of the details, but was struck by the sheer magnitudes:

• Approximately 528 million poor (below $2/day) Muslims in five countries: Indonesia, Bangladesh, Pakistan, Nigeria, and Egypt
• Approximately another 100 million poor Muslims in India
• Incredibly high degrees of financial exclusion of Muslims in OIC countries and India (67-80% of Muslims have minimal or no contact with the formal banking sector)
• A recent Consultative Group to Assist the Poor (CGAP) study by Karim, Tarazi and Reille (2008) reports results suggesting that large numbers of poor Muslims in various countries reject all forms of loans, including Grameen-style microloans, on religious grounds
• "Islamic microfinance" using the same ridiculous and insulting (sorry, I couldn't resist taking another shot at the nonsense that is marketed in the name of Islam) 1970s-style murabaha property flipping and other inefficient structures has failed miserably, keeping this subsector to 1% of overall microfinance even though Bangladesh, the epicenter of microfinance, is obviously mostly Muslim. Apparently, the poor illiterate Muslim majorities want something more than the cosmetic and expensive "Islamic" brand name

I have spent far too long arguing with highly-paid bankers, lawyers, and Islamic banking experts regarding the permissibility of conventional mortgages, and suggesting to their potential customers that their portrayal of Islamic jurisprudence is incoherent (e.g. what constitutes a loan as qard and what does not). With mostly illiterate poor populations, that is of course a lost cause, and the highly paid bankers, etc. have -- so far -- made it clear through their actions that they have no interest except for public relations purposes.

The structure that I proposed is a hybrid between the interest-free model of the Scandinavian JAK bank and the well known Rotating Savings and Credit Association (RoSCA) models that are popular in all Islamic societies (as well as non-Islamic developing countries). This model is known in the Egypt, where I grew up, and the rest of the Arab world as gam`iya (financial cooperative). It is a practice that the majority of traditional jurists, including the late Bin Baz have approved.

The need for a hybrid of the two interest-free models follows from shortcomings of each:

• The JAK model is very much focused on mortgage financing, where member loans are secured by the properties financed. (i) This makes it applicable, for example, as an alternative structure for North American or other countries' mortgage markets, but not for the microfinance sector. (ii) Also, the JAK model lacks the ability to utilize social capital through peer-monitoring, which is indigenous to RoSCA structures and successfully adapted by Dr. Yunus in his group-lending Grameen model.
• The RoSCA model suffers from (i) fragility, because one person's withdrawal would ruin the finance facility, (ii) symmetry of contributions to the pot, which makes it difficult for financing smaller consumer and larger business microloans simultaneously, (iii) does not have the flexibility to provide equity positions and/or return on savings for older/richer participants who do not need to receive the pot but would like to participate and receive a return, and (iv) is not conducive to growth and institutional development into bank or credit union structures.

I plan to summarize my proposed hybrid structure in the next posting.

Rebooting Islamic Finance: It's Time

I have been very critical of Islamic finance as it has evolved since the 1970s: an inefficient part of the international financial system that served no purpose except line the pockets of lawyers and experts. Now that the tools of structured finance have been proven to be as much a disaster as others and I had warned, perhaps participants in this industry - many of whom are sincere, I am sure - will hopefully abandon their response to my critiques: "what is wrong with SPVs, that is how all finance is done with success." 

Perhaps now is the time to switch from negative criticism to positive suggestions of how to do things differently.

This is not an area where I believe in keeping ideas to oneself until one publishes them or makes some money in consulting fees for proprietary structures. Also, it is an area where open discourse may help to improve upon proposals...

So, here we go, starting with possible innovations in microfinance structures that I hope to start investigating experimentally this summer: و على الله قصد السبيل

Substance over form, finally!

Following early statements by Gordon Brown on the need for proper financial regulation, Secretary Geithner has finally decided that economic substance should supersede form in financial regulation

To that end, Mr. Geithner said: “Financial products and institutions should be regulated for the economic function they provide and the risks they present, not the legal form they take,” Mr. Geithner said. “We can’t allow institutions to cherry pick among competing regulators, and shift risk to where it faces the lowest standards and constraints.”

His full statement is available here.

Now, if only an Islamic jurist would say the same... Oh, wait a second, they have been saying that for centuries, including ibn Qayim in I`lam al-Muwaqi`in and the Ottoman Empire's jurists in Majallat al-Ahkam al-`Adliyya. The problem is not about rhetoric, but practice and implementation. I hope for everyone's sake that "substance above form" will become the practice in all financial circles.

More on rating agencies and sukuk

During the boom years, many were cheering the absurdly mispriced and risky sukuk issuances, and the rating agencies who approved them. I have listed a number of the problems with sukuk structures in my book and elsewhere. Now, it has become clear that those S&P and Moody's were simply engaged in a race to the bottom:

Oct. 22 (Bloomberg) -- Former executives from Standard & Poor's and Moody's Investors Service told lawmakers today that credit raters relied on outdated models in a ``race to the bottom'' to maximize profits.

Jerome Fons, a former managing director of credit policy at New York-based Moody's, told the House Oversight and Government Reform Committee today that originators of structured securities ``typically chose the agency with the lowest standards, engendering a race to the bottom in terms of rating quality.''

Representative Henry Waxman, the committee chairman, said that the recent history of the credit rating companies ``is a story of colossal failure.'' ``The result is that our entire financial system is now at risk,'' Waxman said.

Thank you, Secretary Powell

Finally, a man of the stature of former Secretary of State Colin Powell has said it:

Mr. Powell mentioned Mr. Khan’s death to underscore why he was deeply troubled by Republican personal attacks on Mr. Obama, especially false intimations that he was Muslim.

Mr. Obama is a lifelong Christian, not a Muslim, he said. But, he added, “The really right answer is, what if he is?”

“Is there something wrong with being Muslim in America? No, that’s not America,” he said.

The quest now is to integrate our thought not only as fully American but also as fully Muslim in the internal American thought processes about financial regulation, international relations, and other areas of political discourse, without being dismissed off-hand as being somewhat alien to our homeland of choice. This is not in any way a violation of the separation of Church and State. Our religious choices determine our preferences for society, and bring a wealth of human history and experience that should enrich the political process without tarnishing its areligious nature. 

It is unfortunate that majority Muslim countries of today have suggested that Islam does not allow separation of Church and State -- contrary to historical evidence dating back to the immediate days following the death of the Prophet (p) -- thus preventing their own wealth of history to inform their policy making positively. It is difficult to blame poorly informed westerners for irrational fear of everything "Muslim" when Muslim leaders in various parts of the world are actively nurturing this fear toward political and financial ends.

"Islamic Economics" and the Financial Crisis

A prominent Islamic economist emailed a description of the current financial crisis and a supposed solution in Islamic jurisprudence, which he characterized by morality, emphasis on equity, and the prohibitions of riba (which he equated with interest) and maysir (gambling). The following was my response:

I think that the broad lines of the current crisis are indeed as you have described them. I'd be happy to discuss the specifics at a later stage, but I'd like to take this opportunity to disagree respectfully regarding the classical "Islamic economics" solution that you are advocating. Let me organize my thoughts in four main points:

1. There is a fundamental tradeoff, as you have suggested, between growth and efficiency on the one hand and equity and stability on the other. In a world where some societies choose a high-growth path and others choose the equitable-stable path, the former societies eventually invade or otherwise overtake the others politically and economically. Hence, there is need for a social contract, which you have put under the banner of morality, to shepherd mankind to the safer more equitable path.

2. Morality cannot be legislated, and reliance on social and economic players to exhibit moral conduct voluntarily is a form of Utopianism. There are numerous verses in the Qur'an and numerous Prophetic Ahadith that explicitly characterize mankind as gluttonous wealth seekers. Pious members who are satisfied with little, etc., as you describe, were a minority even immediately following the death of `Umar ibn al-Khattab, as evidenced by the grand fitna and the later paths pursued by the Umayyads, the Abbasids, etc.

3. Islamic jurisprudence used and refined many of the earlier scriptural and human-legal provisions for creating the more equitable and less turbulent path, through restrictions on leverage, fragmentation of estates, redistribution of wealth, etc. In the arena of finance, the prohibitions of riba (absolute) and gharar (relative, but absolute for the extreme of maysir) can be seen as regulations of risk taking. In the ancient world, this was accomplished by permitting certain contracts and forbidding others. I have argued that adoption of this approach in the modern era of financial engineering, where transaction costs of circumventing the prohibitions have become minimal, is incoherent.

4. The mirror-image-problem of this product-oriented regulation of financial markets has been at the core of the current financial crisis. Insurance markets have been generally regulated to keep them from becoming gambling (maysir) tools. For instance, I cannot buy an insurance policy against another person's losses, lest this may be at best a form of gambling and at worst an incentive to harm that other. Credit default swaps and other modern derivatives may equally be seen as forms of insurance, but ones that lack sufficient regulation to prevent gambling. I was tempted in July to buy put options on oil, thinking that a global recession is inevitable and the price of oil will have to fall. I stopped only because I think that this is a type of maysir, because "markets can remain irrational indefinitely, certainly longer than I can remain solvent." Numerous others made the bets, I am sure, and conditional on counterparty risk, some have made small fortunes doing that. The incentive to gamble is simply too great. 

There is nothing uniquely Islamic about modesty, contentment, shunning risk and gluttony, or even the prohibitions of riba and maysir. Even those who do not believe in revelation (to Moses, Jesus, or Muhammmad; p) can be convinced that those ancient prohibitions and injunctions were distillations of human wisdom over the millennia. Calling those injunctions and prohibitions "Islamic" strikes many as exclusionary and encourages others to engage in hateful and myopically-triumphalist celebration of our collective failure (Islamic finance is just as guilty as conventional finance for bringing about the current crisis).

It is not clear that majority-Muslim societies are particularly better equipped to solve the collective-action problem required to find a low-growth-low-risk social contract. In a world where others will pursue higher-risk-higher-growth paths, it is not even clear that pursuing that lower-risk-lower-growth path is warranted (isn't that how Madinah lost to Damascus during the time of Mu`awiyah?). Is it possible to reconfigure our rhetoric to make it less exclusionary (avoid separatist and triumphalist use of the "Islamic" brandname) and to convince multiple populations at very different stages of economic development to shun fast growth in favor of greater equity and stability? The dialogue would likely be very similar to the one witnessed in negotiations over polluting rights. Perhaps we can learn more from the successes and failures of this global dialogue than we can from inspecting ancient laws for outdated modes of regulating financial markets.