Friday, June 17, 2005

Islam and Economic solutions -- Part II (the tragedy that is "Islamic finance")

In previous posts, I spoke of the ruses (Hiyal shar`iyyah) used in so-called "Islamic finance", including bond structures marketed under the Arabic name Sukuk, which is a synonym of the traditional Sanadat. The problem is not just about a few corrupt people willing to sell their knowledge of jurisprudence to the highest bidder (that has been around for centuries, and prompted the famed "closing of the doors of ijtihaad" in late medieval times). The bigger problem is the marketing of "Islamic finance" as an solution to Muslims' economic malaise.

The history of this thought -- called "Islamic economics" -- is more than 50 years old. Its contemporary proponents, including writers such as Umar Chapra, argued that a financial system based exclusively on equity-financing will lead to higher rates of economic growth, as well as higher rates of income equality. In other words, Islamic economists rejected the classical economic problem of trade-off between efficiency and equity -- arguing that "the Islamic system", which is of course only vaguely based on Canonical Islamic Texts, is simply superior along both dimensions. Much of the argument is based on early Islamic thought, by jurists and others, which claimed that the prohibition of riba (now fashionably equated with all forms of "interest", despite obvious Canonical differences in Hadith; see my paper "An Economic Explication of the Prohibition of Riba in Classical Islamic Jurisprudence") is based on the inequity of exchanging something (interest) for nothing (no tangible compensation).

Needless to say, when contemporary bankers and jurists (e.g. the late Dr. Sami Humud) looked into classical jurisprudence, they found that the leaders of all eight major schools (Sunni and Shi`i) allowed increasing the price in credit sales, as a compensation for time. One would think that this would end the debate: (OK, so not all types of interest are forbidden). However, the rhetoric of "Islamic" meaning "interest free" had sunk too deep into Muslims' psyche. Thus, a new cadre of bankers and jurists came to the fore to disguise interest as profit, rent, etc. In the process, they found the activity quite lucrative:

Now, a typical "Islamic finance jurist" does not make as much money as a successful "Islamic finance lawyer". The latter category consists almost exclusively of New York and London lawyers, mostly non-Muslims, who rely on 'Islamic bank jurists' to legitimize their structures as "Islamic". On the other hand, those lawyers are bona fide, in the sense of having the proper education, licenses to operate wherever they do, etc. Being mostly non-Muslim, there is no problem with them profiteering from the brand-name "Islamic" -- it is merely a job for which they collect fees.

The real problem lies with the "Islamic finance jurists", many of whom have no formal degrees in the area, and many others stretching their areas of expertise to enhance their marketability. The financial incentive faced by those "jurists" is staggering. For Pakistani, Malaysian and Arab jurists, their annual incomes before involvement in Islamic finance would be mostly below $30,000, for successful ones, substantially lower for others. Ones who are successful in Islamic finance can serve on roughly 10-15 "Shari`a boards", collecting retainer fees in the range of $10,000 to $50,000 per year per board (rising in rare instances to $100,000 per year for some board memberships), in addition to daily compensations for attending meetings, etc. in the range of $3,000 to $5,000 per day. Non-pecuniary benefits include flying first-class worldwide, staying in 5-star hotels, and receiving various gifts -- one reported to me that he received a gold Rolex watch from a Gulf prince, which he couldn't wear (Muslim men are not allowed to wear gold!), so he sold it!

So, if you get into "Islamic finance" you can multiply your annual income by a factor of 10-50, or even 100-fold. Once you get addicted to the new lifestyle (and all people are vulnerable to such addiction), how can you resist the temptation to keep this scam going. Yes, I mean to use the word "scam". The complicated structures of "Islamic finance", which use medieval contracts to synthesize contemporary financial transactions, are less efficient than their conventional counterparts. The creation of various special purpose vehicles (SPVs), etc. costs money, which is charged to the "Islamic" customer.

In other words, the "Islamic" customer gets the same financial product or service, but at a higher cost (to cover the expenses of "Shari`a scholars", lawyers, SPVs, etc., that other banks do not have to incur). All they get in return is a certification by those jurists-for-hire that their product is "Islamic". That is similar to indulgences (sukuk al-ghufran) marketed by the Catholic Church prior to Lutheran reformation. Strangely, jurists at various conferences find nothing wrong with that. One jurist at a recent conference in KL chided me and others for raising the issue of their fees and potential conflicts of interest. "The lawyers make much more money", he said. (Yes, but they do not sell religion!). And, he said, "you cannot call anything 'Islamic' unless it is certified by a Shari`a board". Couple this with the fact that the same few jurists are serving on all the different Shari`a boards, and it becomes one of the most self-serving religious-based arguments made in many centuries. Interestingly, those "scholars" are always complaining that there aren't enough "scholars" with knowledge of finance, jurisprudence and English. That, despite Islamic universities around the world producing thousands of graduates each year!!

To end this posting, let me pose the following question: Is the solution offered any better because of its characterization as "Islamic"? The answer has got to be no: the "Islamic" customer gets the same thing for more. This means that financial needs that were not met with the conventional sector are still not met by its "Islamized" version, and there is a dead weight loss (jurist and legal fees, SPV costs, etc.) borne by the very poor Muslim societies that fall prey to "Islamic finance"-vultures (be they London and New York bankers and lawyers, or Pakistan and GCC "scholars").

So, to address our "Islam is the solution" heading, one must qualify what one means by "Islamic" in "Islamic solution", based on the source, and the source's incentives.


Anonymous Anonymous said...

I truly appreciate your writings and urge you to continue the good work. I check your blog daily.

Have you ever tried to get in touch with these scholars and advise them? I fear that the more you go off on them on your blog the more barriars it will put up between you and them, making them deaf to your valuable insights.

So it seems that you are leaning towards a more "maqaasid" (aims of the shariah) driven Islamic finance versus medevial contracts. How do you propose we can take the next step towards this?

2:05 AM  
Blogger Mahmoud El-Gamal said...

Thanks, I'll try my best. I truly think that the current crop of "jurists" is beyond communication. I do think that we have to make the substance of Islamic finance the main guide, rather than resurrecting inefficient medieval forms. I have some suggestions in current and future formal publications, and look forward to starting some discussions when the time is right.

I am sorry to have to "expose" those jurists for what they do, but I have tried to fix this "munkar" (blameworthy activity) directly and failed, so now, I have to try verbally.

My main fear is that the name of Islam will be tarnished for generations because of the irreosponsible activities of the current generation. Hopefully, something good can still be done within our lifetimes.

12:29 PM  
Anonymous Mohammad Fadel said...

The personal corruption, or lack thereof, of Islamic advisers is interesting, but should not cloud a deeper issue in the structure of pre-modern Islamic law, and that, in my opinion, is its strongly libertarian character. In theory, doctrines such as siyasa shar'iyya gave the government the right to regulate otherwise permissible (at least from the religious perspective) conduct in order to further the public good. In fact, this power was not often used in the pre-modern era, and in fact, jurists still act as though the fact that something is "permissible" means that the state has no business preventing people from doing it. As a result, it is my intuition that Islamic law in its pre-modern form was significantly hampered in dealing with collective action problems. Matter of fact, I don't even know if contemporary jurists understand the notion of a collection action problem, although some rudimentary thinking on this can be found in discussions of furud kifaya.

The neo-libertarianism of pre-modern Islamic law implicitly supports contractual arbitrage since it fails to consider the relationship of private contracts to social welfare. In Arab societies, given the often perverse incentives created by government and social institutions, even pareto efficient trades can be expected to generate significant negative externalities. Nevertheless, Islamic law, at least in the form formulated by pre-19th century jurists, is unlikely to provide a guide for a rational system of the regulation of private economic activity, and in some cases, may be a positive hindrance, e.g., Pakistan and land reform.

6:08 PM  
Blogger Mahmoud El-Gamal said...

I agree completely with Mohammad's analysis. In a presentation that I called "Macro vs. Micro considerations in Islamic financial ijtihad", I suggested further that contemporary jurists are less cognizant of what I call macro effects (and Mohammad calls collective or collection action effects), especially within the dynamic system of Shari`a arbitrage.

Mohammad being trained as a Maliki jurist would recognize some of the ideas that gave sadd al-dhara'i` a strong position in the Maliki toolkit, but he and I clearly agree that the important issues require a political and economic analysis of social welfare, which can then inspire juristic and legal analyses. Unfortunately, that is lacking even in Malaysia, where juristic decision have been centralized. I think that is in part driven by juristic training, as well as conflicts of interest (the same jurists also rely for the bulk of their income on consulting for private financial institutions). This is equally a problem for the Shari`a boards of AAOIFI and IFSB, who are also the primary beneficiaries from the "Islamic finance" industry. In that sense, I think the absence of social welfare analysis and corruption issues are deeply intertwined.

8:48 PM  
Blogger Mahmoud El-Gamal said...

I posted the presentation I just mentioned at MacroMicro

9:00 PM  
Blogger heraish said...

How do you respond to this. Particularly the near unanimity of scholars on the fatwas issued and no dispute with the "board scholars"?

The first two sessions were followed by two parallel sessions on graduate research. The first session was moderated by Ibrahim Warde. Mr. Walid Hegazy’s presentation was about fatwas (Islamic legal opinions) and the fate of contemporary Islamic finance. He essentially raised three points. Firstly, that Islamic finance fatwas are given without consideration of the maqasid of Shari’a and on the basis of narrow legal rules. Secondly, the issue of conflict of interest i.e. that the Islamic finance fatwas are issued by muftis (Experts of Islamic law) who are employed by the Islamic financial institutions. Thirdly, that this procedure may result in a system of hiyal (in general terms: system based on exceptions) where the original maqasid of Shari’a are lost. Nizam Yaqubi who is a Shari’a scholar disagreed with Walid and raised several points against his conclusions. With respect to the point of conflict of interest he said that the Higher Council of Islamic banks has collected over 6000 fatwas and ninety percent of them are consistent. Over a hundred muftis gave these fatwas from various parts of the world often without knowing each other, which suggest that the issue of conflict of interest is not real as otherwise there should have been a greater inconsistency in the fatwas. He further said that it might be beneficial for Walid to read these fatwas and analyse how many of these are against the maqasid of Shari’a. He further urged Walid to include in his study the difference between hiyal and makharij and to discuss permissible hiyal and impermissible hiyal as well as the difference between talfiq (patching) and ikhtiyar (choice).

3:49 PM  
Blogger heraish said...

3:50 PM  
Blogger heraish said...

assalamu alikum brother Mahmoud:
Do you still stand by this from
A Basic Guide to Contemporary
Islamic Banking and Finance written by yourself?

The fundamental difference between the two cases cannot be overemphasized.
From a religious point of view, writing a contract that
intentionally abides by Islamic Legal injunctions is very different from
writing one which does so by mere coincidence or based on human reasoning.
Moreover, from a legal and practical point of view, the first
contract is guaranteed to continue to abide by Islamic Law, while the
latter may change with circumstances. Such change can impose a significant
cost on the Muslim who has to seek refinancing to abandon
Rib¯a and live in accordance with the Sh
5Those educated in contemporary economics and finance will recognize the importance
of this rule in effecting desirable economic efficiency and fairness.

12:02 PM  
Blogger Mahmoud El-Gamal said...

Yes, I stand by that statement, which essentially says that the forms of contracts also serve an important function. That does not mean that we accept any contract form that jurists approve based on similarity to historical contract forms. It means that we need to understand the substance of prohibitions, and to construct contemporary contract forms that protect that substance: something that I find disastrously missing in Islamic financial circles today.

3:56 PM  
Blogger heraish said...

Jazakallah kheir for this response. It was helpful. You are definitely raising pertinent issues.

4:07 PM  
Blogger heraish said...

Corruption of Scholars:
It is true that this may be a factor affecting an individual scholar's opinions. That is exactly the reason they have a board so that this problem is mitigated. The second point is that there are a couple scholars involved in this field that have other "gigs" and are not totally dependent on "board based" income. Some have original contributions outside the financial field and have even withstood strong governmental pressure on others issues

It seems that they actually believe in what they are doing
and corruption may not be as big an issue as you seem to believe. If a shari basis are given for a given disapproval I am sure they would be willing to look at it. I am particularly referring to Usmani and Qaradawi.

Wallahu Alem

8:07 AM  
Anonymous Anonymous said...

It is rather odd--some 10 years ago I used to hear about Malaysia in such derogatory terms. Oh, you can do Islamic Finance properly, or you can do it the "Malaysian" way. It was always assumed that the Malaysian model of justifying bai al-inah was a major source of laxity. Yet, rather than just chock that one up to differences of maddhabs and try to learn, nobody even looked seriously at the Malaysian model.

One thing that it does have is a shariah board on Bank Negara. All supposedly Islamic deals go through them. No need to find your own, no way to do any 'fatwa shopping'.

Nowadays, besides the random lease-buyback that in almost all aspects (i.e., lessee still has to maintain property), appears to be just a regular bond deal, you can find all sorts of structures which are really bastard children of Islamic finance: a tawarruq of wu'ud that amounts to an "islamic swap" (overheard: we can do halal pork bellies), charging for a wa'ad (how can we complete the market? seems a pretty good shot at it), etc, etc. All come from fatwa shopping and all are some examples of what happens arbing shariah scholars.

The Malaysian model should look pretty attractive now.

5:54 AM  
Anonymous Anonymous said...

I beg to differ, anonymous! Malaysian models are still sheep in wolves clothing, even if endorsed by Bank Negara.

So far, what Bro El-Gamal have said, he has written it concisely, and eloquently, w.r.t all the falsities of islamic finance.

I am a Malaysian Muslima, caught up in employment as a user of islamic finance, ie. my employer is a corporation ever hungry for leverage, with or without the stamp of "islam".

Its easy to condemn the current islamic finance and their sell-out scholars, but are the alternatives? In a globalised world, a society can't survive without credit.

10:22 PM  

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