Saturday, April 15, 2006

A (Forceful) Call for Mutuality In Islamic Financial Intermediation -- Or: Can "Islamic Banks" Be More Usurious Than Regular Banks?

Although this may be unorthodox, I have decided to post my presentation before actually delivering it. I have posted some of the slides from the presentation that I plan to make at the Harvard Islamic Finance Forum (April 22) here. I summarize the main points below (slides can be cryptic):

  • The case for mutualization in Takaful (insurance alternative) is obvious. The very name chosen by the industry (meaning mutual-protection or guaranty) suggests this mutuality. In fact, however, mutuality in that industry is largely a fiction. In reality, so-called takaful companies are owned by profit-oriented shareholders, and thus the juristic solution of avoiding gharar through making the contract non-commutative (gharar only invalidates commutative financial contracts) is contrived through unconvincing claims that the shareholders voluntarily contribute insurance claims payments to their customers (this also raises many juristic issues on hiba and its rules, but that is not the point here).
  • The juristic solution can make economic sense if we align rhetoric with reality, and actually make takaful companies mutually owned. In other words we need to shift focus from contract forms to corporate structure and incentives.
  • The same argument can be made for the avoidance of riba. In fact, I argue, riba is just an extreme form of gharar, where the latter is profitable trading in risk, and the former is profitable trading in credit. Of course, trading in credit is the same as trading in credit and interest rate risks -- as every undergraduate student who has studied money and banking knows. Contrary to the statements of classical jurists and Islamic economists, the prohibition of riba cannot be explained by the lender earning a return without taking commensurate risk. (If that were the case, lenders would be competing for the opportunity to get such riskless return, and the interest rate would fall to zero! You would also need a monopoly constraint, that the borrower could not seek lenders at lower rates, but then we are in other impermissible territory, and not speaking only about riba.) On the contrary, the problem with riba may arise precisely because credit risk is so difficult to quantify, and hence it is difficult to draw a line between legitimate interest and predatory lending or loan sharking (the Fed and the OCC are struggling with cases of possible predatory mortgage lending to minority groups in the U.S.; precisely because credit risk is so difficult to calculate).
  • To make a long story short, the fear of predatory lending or injustice in credit extension, riba may be best solved by excluding the profit motive from credit extension. In reality, so-called Islamic banking providers may in fact be committing a worse riba than the banks from which they sprung and which they continue to serve: If they charge extra interest over and above the level that was profitable to the bank in the first place (what I have previously called rent-seeking Shari`a arbitrage), then they may increase the riba (unjustly priced credit), or introduce substantive riba where none may have been before. Take the profit motive out, and you don't have to worry about that. Shift the focus from contract forms (which invite rent-seeking legal arbitrage) to corporate forms and incentives.
  • As evidence of partial agreement and disagreement with classical Islamic scholarship, I refer back to Al-Qarafi's Furuq, especially the point that interest-free loans would themselves have been riba (how do you know that zero interest is the fair rate; think of all the 1970s debates about indexing, inflation, etc.). Loans were excluded from the rules of riba, he says, because of their charitable nature. Any compensation would transform a loan into a sale, hence requiring application of the rules of riba to ensure equity in exchange (see my earlier analysis of Ibn Rushd's analysis of the rules of riba and argument that it is all about equity in exchange). In other words, the solution to the problem of riba was non-commutativity, i.e. the same as the solution to the problem of gharar. My argument is that non-commutativity in finance requires a mutual corporate form, and cannot in reality be implemented by for-profit corporations, who have every incentive to exploit contract rules (legal arbitrage) for profit.
  • Of course, Qarafi's argument that l`ariya or simple loans would become leases if compensated, and that riba is not envisioned in leasing, predates the structured financial uses of leases as loans (originally in 1980s leveraged buyouts, and most recently in so-called Islamic bonds -- marketed under the name sukuk). Economically, those leases are not sales of usufruct, but sales of credit, and hence should be made subject to the same rules of riba as loans. As proof, check the legal provisions that require continuation of the rent payments (recharacterized as price repayment) even if the property is destroyed -- i.e. where there is no longer usufruct. There is no lease there, only a loan, which -- compensated -- is a sale of credit wherein we need to worry about riba.
  • Hence, I argue, the solution is in mutuality, through credit union, mutual saving banks, and other forms that originated in the west, driven mostly by faith communities and working-class organizations wishing to avoid unfair lending practices of commercial banks.
  • I can't post copyrighted material on the web, but you can look at Wall Street Journal on March 7, 2006, discussing the tremendous growth of credit unions in the U.S., and commercial bankers' attempts to stop their growth. I will also show two quotes by Sh. Saleh Kamel, which suggest that Islamic banks are in fact mutuals ("depositors are partners...") and that they have a social agenda (provide investment opportunities, etc.), which in fact the bulk of Islamic finance has not been.
  • The recipe that I am suggesting is simple: MUTUALIZE. Abolish the profit motive in Islamic finance, and align its rhetoric with reality. Then, the industry will not be dominated by western banks who are seeking rents -- by charging higher interest rates to a captive Muslim audience under different guises.

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Blogger Jamal L. Mahmood said...

I know this is an old post by now, but I have just come across it. I am a financial planner who has a lot of experience dealing with mutual insurance companies, and who believes strongly in credit unions as well, so your call for mutuality resonates with me. How have you found this proposal of yours to be received? I don't see too much traditional scholarship that supports it (which is frustrating). Too many of my clients are happy just keeping their money in regular banks and donating the interests (thereby still supporting the interest superstructure), and look at me like I have three heads when I suggest to them that the best "Islamic" move would be to move their savings to a credit union.

In short- what's the state of mutuality in Islamic finance since you proposed this?

2:03 PM  

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