Tuesday, January 26, 2010

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.

Saturday, January 23, 2010

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.

Sunday, January 17, 2010

UNEPFI Membership: Will Islamic Finance turn to positive injunctions?

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).

Friday, January 08, 2010

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

Sunday, January 03, 2010

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?