Wednesday, April 19, 2006

Riba as an extreme form of gharar -- Thinking aloud

I had taken it for granted that if you accept the view of the forbidden bay`u al-gharar as trading in risk, then you would recognize riba as an extreme special case of trading credit risk. Dr. Siddiqi objected that the essence of gharar is uncertainty, but -- he said -- there is no uncertainty in riba. I guess classical writers and Islamic economists for too long have been saying that riba is forbidden because the interest received is not compensation for commensurate risk, to the point that people have taken this to be true. This means that I need to have a full section dedicated to this issue in my academic paper. For now, let's see why it should be obvious that riba is an extreme form of gharar.

Economists regularly divide the types of asymmetric information that lead to market failure (due to uncertainty) into two categories: adverse selection and moral hazard. Let's look at the manifestations of those problems in riba and gharar, using examples from canonical texts and classical jurisprudence. We begin with adverse selection:

  • Adverse selection in gharar examples:

    • Defective merchandise: seller knows if the good is defective but buyer doesn't
    • Diver's catch: diver knows if this is a good spot to dive but buyer of catch doesn't
    • Unborn calf: seller knows if cow has had previous miscarriages, etc., but buyer doesn't

  • Adverse selection in riba examples:

    • Debtor knows if he has defaulted before, creditor doesn't
    • Debtor knows better the chances of solvency at maturity of debt

Then, of course, there is moral hazard:

  • Moral hazard in gharar examples:

    • Defective merchandise: temptation to deliver lowest quality acceptable goods
    • Diver's catch: temptation to shirk
    • Unborn calf, unripened fruit, etc.: temptation not to care for cow or orchard, since risk has already been transferred to buyer

  • Moral hazard in riba examples:

    • Of course, this is the classical example: debtor has an incentive to take large risks with the creditor's money, since all return up to the interest payment goes to creditor, and -- depending on bankruptcy laws -- liability may be limited.

Classical writers looked at the creditor/debtor relationship as creditor receiving return without commensurate risk, which is obviously incorrect. If that were the case, other crediors would compete for that riskless return opportunity, driving the interest rate all the way to zero. The problem is that the risks are difficult to quantify, and there is too much asymmetric information, which modern financial markets and institutions reduce with various structures and regulations:

  • The creditor is exposed to credit risk and interest rate risk, thus favoring that the debtor takes very little risk with his money (explaining in part why a deposit, which is a contract of trust, turns into a loan, or contract of guaranty, if the depositary uses the property). However, due to moral hazard conditions, debtor may be tempted to take excessive risk.
  • The debtor is exposed to business risk and bankruptcy risk. Of course that risk was substantial not only in antiquity, but well into the modern age, where quasi-slavery still resulted from excessive indebtedness to loan-sharks, white-slave traders, etc.

So, we can see that for the creditor (buyer of credit risk), the risk is very extreme, since incentives could encourage the debtor to take excessive risk and expose him to the possibility of losing all his money.

For the debtor, the risks may be substantial if bankruptcy laws are not in place to protect him, and may still be substantial if default makes it impossible to obtain further credit or get into other business arrangements.

Hence, riba is an extreme form of trading in risk (credit risk), or an extreme form of gharar.


Blogger Mahmoud El-Gamal said...

While that's the example that I gave, the argument easily extends to other forms of riba.

Consider, for example, riba al-fadl -- wherein there is no interest -- and the argument by Ibn Rushd that I used as a basis for "marking to market" being the solution to riba. In that argument, Ibn Rushd basically says that the reason for making riba al-fadl forbidden is twofold: (1) if the goods of the same genus are of the same type and quality, equality in barter ensures equity, and (2) the parties are not obliged to trade with one another -- hence if the 1-to-1 trading ratio is not fair, they can seek equity by first selling one property and buying the other with its proceeds (hence quoting the Hadith of Khaybar dates in my paper on riba).

So, you can see that there is an element of gharar even in barter riba, since the parties have no mechanism in that simple trade of ensuring that the barter ratio (2-for-1 in the dates Hadith) is indeed fair. The solution is simple by ensuring that prices are marked to market. See

5:14 AM  
Blogger Islamic Law, Etc. said...

You've mentioned:
"Classical writers looked at the creditor/debtor relationship as creditor receiving return without commensurate risk, which is obviously incorrect."

Are there any other Modern Economists and/or Islamic Jurists who also hold this opinion?

4:29 AM  
Blogger Mahmoud El-Gamal said...

All modern economists (with the exception of Islamic economists) whom I have read agree that the lender is exposed to credit risk, interest rate risk, and potentially liquidity risk. If you are asking about modern Islamic economists, no I have not read that assertion being made by others, but that should not mean that it doesn't make sense. Most parts of economic analysis are universal, and apply equally to Islamic and other societies.

With regards to modern jurists who have made the argument about credit risk, I think that one can find proof for this view in classical juristic writings -- which are mostly regurgitated by modern jurists: Various classical methods of securing debts (e.g. through rahn, third party guaranty, etc.) implicitly prove that classical jurists recognized the need to ameliorate credit risk (but not to eliminate it completely, as entitlement -- or istihqaq -- by third parties may make a prior claim on pawned property).

6:43 AM  
Blogger Islamic Law, Etc. said...

"Most parts of economic analysis are universal, and apply equally to Islamic and other societies."

I agree, and I would think that it would be obvious to anyone that wanted to do analysis.
Would you say that many "Islamic" Economists have mixed up positive and normative values when trying to formulize an "Islamic" economics and thus mixed the mark?

What I have read so far it doesnt seem that anyone has really formulized an overall theory of islamic economics, instead it is either a re-hash of fiqh debates, emphasis on on normative values and ethics, or actually discussions of finance methods alien to the economics debate (meaning directly).
I would love to hear your thoughts and/or corrections of my suppositions on this.

8:00 AM  

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