Economy Headline — 20 May 2013
Finance in a non-Banking World

Sarfraz Wali

Introduction

The world financial system came into global focus in the aftermath of the 2008 financial crisis that saw companies such as Lehman Brothers, Bear Stearns and AIG effectively collapse under the liabilities that they had amassed.

Many questions were raised but as has happened before, such as the depression of the 1930’s, the mainstream narrative that was pushed by the establishment was that what we had seen was no more than unavoidable risks that are part and parcel of markets and the best approach is to try to ameliorate risks and not seek to undertake a fundamental review of the system as a whole.

Such risk management was in the form of better regulation, as if the failure was a failure of regulation rather than a fundamental systemic failure of the system.

Debt vs. Equity Financing

In the Islamic Economic System (here forth referred to as IES) the financial model is based on Equity finance as opposed to interest based debt finance. In this context, equity refers to funds available from savings as opposed to funds borrowed from banks on interest.

The way equity finance works is capital partners enter into partnership with other capital partners or partners who bring the entrepreneurial aspect alone to the partnership and engage in a risk and reward sharing contract. A number of distinct company structures exist, such as Mudharaba, Al-‘Inan, Al-Abdan etc, to cater for the various combinations of capital and entrepreneurial partnership roles but the essential principles are the same.

In all such structures, profit is shared according to a ratio (pre agreed between partners) and the losses are in proportion to the capital share of the partner. There is no concept of limiting the liability of the partner. In the case of the body partner, that is the partner who only inputs enterprise without any capital, the loss is only upon the effort exerted as there was no capital investment by that partner. The company is thus formed of partners not their capital, unlike Capitalist companies where the corporate entity is formed of the capital contributions of the investors.

The Prophet Muhammad SAW said

“The loss (Al-Wadhi’a) is upon the capital and the profit is according to what they stipulated.”

Incentives for Equity Finance

The question arises of what incentive may exist to bring capital into such arrangements unlike the incentive to loan money on interest or loan equity without risk to personal assets. To understand this question, one needs to consider other rules and realities in the IES, which discourage the hoarding of wealth and this ensures funds find their way to new and creative business ideas creating an environment ripe for innovation and employment.

These rules include the following:-

a)      Zakat, a tax levied on unused wealth at the rate of 2.5% payable annually.

b)      Prohibition of hoarding money which is the medium of exchange. This means it is not allowed in the IES to remove money, which is the means of facilitating trade, from circulation for no purpose. This is contrary to saving for a purpose. This creates an imperative to think about means of investment.

 

c)       Lack of interest bearing bank accounts or any other interest based investment vehicle, which motivates other creative forms of money investment.

How do large scale industries cope without public equity market availability?

As the Islamic company structures are formed of partnership and agreement between partners as opposed to their capital, this is a natural limiting factor to how large the Islamic structures can scale.

In the joint stock PLC structure, shareholders do not contract with each other, instead their share capital contracts with the capital of other investors and this enables them to grow to a significant scale as no inter-partner agreement is involved as to who can and cannot be included in the ownership of the company entity. This contrasts with the Islamic model were partners need to engage on offer and acceptance amongst each other as the company is formed of their person and not their properties.

The question of how natural monopolies or industries such as oil and gas exploration would survive in an environment without conventional stock markets arises. Such industries often have huge start-up costs that need thousands of investors pooling their capital to make such projects viable.

In the IES, there is a separation between private property, public property and state property and such projects fall within the purview of public property. Public property is owned by the public at large but managed by the Islamic State which levies a charge for the supply and maintenance of such industries. Therefore the pooling of funds still occurs but under the provision of service as opposed to the profit motive.

Furthermore, different rules relating to intellectual property protection means that innovation proceeds at a rapid rate as competitors are constantly enhancing product features leading to smaller companies making more frequent improvements as opposed to larger companies making larger but less frequent product developments. This also offsets the need for large scale companies and smaller companies are far more conducive to increasing employment levels.

How will Equity Finance works where loans are not available?

There will be far greater disposable income and savings in the IES, due to a number of factors too plentiful to list but as an insight one can consider the following:

The monetary unit is the gold and silver currency which will cause a stable to mild deflationary environment which will ensure incomes can easily keep pace with prices unlike the scenario we see with monetary inflation eating into the disposable income of families. Unlike in the 1950’s through 1970s, both partners often now need to work to maintain the standard of living that the previous generation enjoyed.

The fact that the taxpayer today is paying more and more for bailouts that the casino behaviour of the financial markets caused in the 2008 crisis and ongoing sovereign debt crisis in Europe, is another reason why we are so impoverished that most people have no savings and rely on borrowing on interest. Compounding this impoverishment is the right afforded to banks to ‘print money from thin air’ and then loan such money back to the government on interest paid back by the taxpayer! Surely it would be fairer on the common man for the government to be allowed to print the money to avoid the interest payments back to the banking establishment, an idea sought by Abraham Lincoln when he devised the green back monetary unit. So the focus should be on the systemic impoverishment under Capitalism and not why the IES does not have such loan facilities.

Finally, unemployment will be lower as smaller companies create more price competition and greater innovation which in turn creates jobs which translates to wealth for all and this means a higher pool of investable funds to fund novel business ideas and further innovation. This contrasts with the mass consolidation of business that has occurred in the Capitalist model were many brands, which cunningly maintain their original brand names to create the illusion of competition are in fact owned by fewer and fewer organisations.

How are other aims of the Financial Sector realised under the IES

What about other functions of the financial sector such as hedging through the derivatives industry, price discovery for various financial products including exchange rates and managing trades through large entities (called clearing houses) that act as financial intermediaries to buyers and sellers?

It is true that such functions encourage trade that would not have otherwise occurred. Such products are non-existent in the IES, so is this not a weakness of the IES one may ask?

Hedging or limiting exposure to risk:

The exposure that is supposedly mitigated through various products, called derivatives, such as Credit Default Swaps, is exposure that is largely created by the idiosyncrasies of the Capitalist system itself and not exposure that is universal to private sector markets.

To substantiate this, consider the following realities that are endemic to the Capitalist version of the private sector:-

  • Business cycles that cause cyclical upturns and downturns in markets due to the abundance of cheap credit (FIAT currency coupled with artificially maintained low interest rates by central banks) and assets bubbles which have economy wide repercussions when prices ‘crash down’ to market fundamentals.

 

  • Weak demand due to weak confidence which is based on irrational fears. This phenomena was referred to by Keynes as ‘animal spirits’ and has also been called the ‘paradox of thrift’. The pre war president Franklin D. Roosevelt summed this phenomena well when he said:

 

“The only thing we have to fear is fear itself!”

 

This fickle nature is not prevalent in the IES due to different fundamental concepts held by adherents of the Islamic belief, such as the concept of Rizq or God provided provisions which make market participants more robust and confident and not prone to such irrational and hoarding and herding behaviour that brings instability to markets that is not dictated by genuine factors such as natural disasters.

 

  • Gold and silver based currency which avoids exchange rate unpredictability removing the need for derivative products that compensate for wild fluctuations in fiat currency based exchange rates.

Furthermore, the idea that risk can be mitigated through derivatives is a complete misnomer and what really happens is that risk mitigation at the scale of individual trades is masked by systemic risk which becomes locked into the entire system. This is a realisation from the prior position, proposed in the 1990’s of the idea of complete risk elimination, an idea embodied in the Black-Sholes model which was manifested in the business model of Long Term Capital Management (LTCM). The idea that risk could be eliminated completely was proven to be false when LTCM failed within 4 years of its adoption of this assumption. The recent credit crisis of 2008 is thus the second climb down from this position with the view now being that even partial risk elimination is at a cost of systemic risk; an idea known as Moral Hazard.

Furthermore, the notional value of the derivative industry dwarfs the size of the real economy by a factor of 20, which proves that it is not in line with hedging risk and paradoxically, such products actually increase the risk of the underlying asset defaulting! This is due to the higher price of such insurance protection raising the market perception of default leading to selling in large quantities which can crash the price of the underlying asset that protection was sought for by those who took protection for genuine hedging purposes.

Having said this about the issues surrounding hedging in the current system, there is some hedging in the IES via the permissibility to engage in forward buying contracts, called Salam contracts, were trade can be locked into a price in the present for a good that will be delivered in the future. This is similar to forward contracts (not to be confused with futures contracts) which when used for genuine hedging purposes, as opposed to speculative purposes, can have positive results on trade volumes in both the capitalist system and the IES.

As far as price discovery, this is not required for derivative products as they are not needed or traded. However foreign currencies can be traded on the international markets (known as the FOREX market) and traders in the IES can obtain foreign currency when importing goods at the spot rate as this has been permitted by the Sharia rules, so the lack of a currency market within the IES will not present issues as far as establishing a fair price for currencies needed traders within the IES when importing goods. It should be noted that only around 3% of all currency trading is relating to import and export requirements according to the Bank of International Settlements.

As far as the clearing house function, what happens in conventional markets is that traders, who often do not trust each other trade with what is known as a central counterparty (CCP); so trader A sells to the CCP which in turn sells onto trade B. Ultimately trader A wished to sell to trader B but lacked confidence in trader B unlike the case with the CCP. This gives financial institutions such as investment banks a key role in facilitating trade and a criticism of the IES could be levelled that without CCP’s the volume of such trade would be impacted. What such critics fail to factor in is that such large trade volumes are usually composed of over blown financial products which are inherently prone to default risk and also the Islamic ethos in the IES for honouring contracts and rights coupled with having sufficient collateral as opposed to massive amount of debt as in the case of Lehman brothers who went a step further that others in hiding their debt and trading with a colossal level of debt which helped them make profits but left them exposed to risk that they simply could not cover. Such realities which drive the CCP concept are eliminated in the IES with its equity financing approach to wealth investment.

What role, if any, will Banks have in the Islamic Economic System

In the IES, conventional retail banks would not exist as there is neither fractional reserve banking that allows for money to be created from nothing, a practise which happens when debts are created under the FIAT monetary system, nor interest based lending.

However a bank function could be in helping capital partners form contacts with other partners with entrepreneurial ideas. Also, there may be a role for them in providing a clearing mechanism to enable people to use credit cards and cheques instead of notes, which themselves are used instead of carrying physical gold and silver. This system (Sakk system) was in fact in use since the time of the Khalif Harun al-Rashid in the 9th Century so would not be a novelty in the IES. However some of these functions could also be undertaken by the state treasury (Bait-ul-Maal).

Conclusion

The myth we are sold is that the financial sector, despite its recent ills, is vital to provide credit which is the lynchpin of growth and wealth creation. The financial sector is thus depicted as the facilitator of the real economy which is where real wealth is created. However the reality is quite the opposite. It has grown disproportionately large; ingesting the loss of jobs from the real economy and now is attacking the real economy through the financial burden that has been placed on each and every taxpayer. The alternative must be brought to the fore of the debate so that the myth is dispelled and the masses are liberated from the financial sector octopus which through its tentacles is drawing real wealth from the efforts of the common man into the hands of the global bankers and financiers.

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(1) Reader Comment

  1. People’s wages are not sufficient to keep up with the increasing cost of living and inflation, it seems as though our complaints are falling on deaf ears with politicians. Perhaps it’s time they took the advice of professional economic crisis specialists. For example the economic specialists at the Orlando Bisegna Index who have helped numerous counties with debt problems, business failures and unemployment, in turn helping many families.

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