Eurozone Predicament – Could Shariah Based Finance Avert the Crisis?

The Eurozone crisis is caused by fractional reserve banking and interest based lending and borrowing. 

A very strong statement/accusation but I will stand by it and I am sure I’m not the only one with that view. In fact, any financial or economic crisis will have roots in the fiat monetary system and lending with interest.

The beginning of the 21^st century saw low interest rates and easy credit fuelling a borrowing binge. This spree caused prices of assets, real estate in particular, to soar. Rising prices ‘invited’ a new group of investors into the market – the speculators, and their presence made things even worse. Banks too made things worse by lending to people who were not really credit worthy or lending to people amounts beyond their ability to repay.

Similarly, in the Eurozone, countries which are not creditworthy were allowed to borrow beyond their means, often hiding behind the credit strength of stronger countries;, in this case, Germany. These governments took advantage of the opportunity and cashed in on the cheap funding to finance everything from infrastructure to social benefits.

Everyone seemed to forget that what goes up must come down; the economy is no exception.

In 2008, everything collapsed. The US housing bubble burst and the whole world followed suit. House prices crashed, banks went bust, stock markets crashed, pension funds lost money, unemployment rose and everything fell apart.

Now everyone is poorer.

Let’s try to imagine if things were done according to Shariah rules. Profit and loss sharing (PLS); a ban on speculative activities and prohibiting the creation and trading of ‘gharar’ and ‘maisir’ infested financial instruments would almost certainly prevent the bubble from appearing in the first place. If the bubble doesn’t exist, it cannot burst.

Imagine if businesses carried out investments on a PLS basis where returns on investment (i.e. cost of funds) matches the actual returns of the investment and not burdened by movements in the rate of interest. The problem with interest based bank lending is that it does not care how much the business is making (or losing); all it wants is their money back plus interest. PLS on the other hand is directly linked to demand and supply and the real economy; when times are good, partners have more to share but when times are bad all partners share the smaller pie (or absorbs the losses). It all boils down to the intention of the investor (lender, in conventional terms); adopting PLS means riding the waves of the economy, insisting on interest based lending could mean not getting anything if the economy crashes.

Imagine if properties are acquired on a (pure) diminishing partnership basis. The buyer (borrower, in conventional terms) and financier jointly purchase a property which the buyer rents at the market rental rate. Being a joint owner, part of the rental is attributable to the buyer him/herself which is then used to purchase equity in the property from the financier. If times are bad, the buyer can choose to only pay the portion of the rental owed to the financier and if times are good, he/she can choose to buy more equity in the property. The rental is market determined and not influenced by movements in interest rates.

Investment bankers are smart people. They are so smart they come up with all kinds of solutions to earn themselves a commission and bonus. However, some of these solutions may only be good for the banks and not for the customers. In most of the solutions, the element of gharar and maisir are clearly present. To make matters worse, some of the instruments can be used to speculate and gamble. These are the recipes for disaster and are exactly what mortgage-backed securities (MBS) and collateralized debt obligations (CDO) are.   The U.S. Senate's Levin–Coburn Report asserted that the crisis was the result of "high risk, complex financial products; undisclosed conflicts of interest; the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street." Shariah based finance would not have allowed such instruments to flourish (although I personally know of some bankers who wanted to create a “Shariah compliant” CDO!).

Therefore, I conclude that the Eurozone crisis (and the global financial meltdown of 2008) was created by;

1. Fiat money;
2. Interest based lending;
3. Unjust and unethical business practices (lending to those who can’t afford, selling potentially worthless credit notes etc.)
4. Gharar; and
5. Masir.

Islamic Finance - a Primer

Islamic finance, as the name implies, is finance based on Islamic laws (Shariah) and is a subset of Islamic economics. The principles of Islamic economics are sourced from the two main sources of Shariah, the Quran and Hadith (sayings of the Prophet pbuh). Contrary to Adam Smith’s theory of self interest, Islamic economics subscribes to the policy of ‘prosper thy neighbour’.

The Western model of finance is based solely on monetary transaction where the bank acts as the middleman between those with excess funds (depositors) and those in need of funds (borrowers). The structure of Western banking is that of a lender-borrower relationship, exchanging money for money. The price of money is interest rates and the determinant of the price is the risk associated with ability of the borrower to repay. The utilisation of the proceeds is of no concern of the bank; it is only concerned with the timely repayments of the loan. Hence, the success of the business does not matter to the bank for as long as loan repayments are met on time and in full by the borrower. The bank does not assume any risks associated with the utilisation of the funds, even if the economy turns into a recession, the borrowers are still contracted to repay the principal and interest back to the bank within the stipulated period. Failing this will result in further monetary penalty, compounded over time.

Islamic and Western (conventional) finance is akin to Petrol and Diesel engines; they run on totally different platforms. Using the wrong fuel would be very detrimental to the engines. Therefore, how it is conducted; the mechanics and modus operandi, pricing, risk management, repayment, recourse, transaction documentation and marketing and sales must conform to the basic Islamic principle of just and equity.

The most significant difference is the basic concept of Islamic finance – risk sharing partnership instead of a borrower-lender relationship. What this means is that all transacting parties must enjoy equal benefits from the transaction and in a case of a loss, all must share the loss equally according to the invested capital. The transactions must be conducted in such a way that none of the parties have an unfair advantage over the others.

Risk management in Islamic finance concerns the viability and potential profitability of a given project and has nothing to do with the investors’ personal ability to repay the capital.

Islamic financial transactions cannot involve anything prohibited by Shariah. The prohibitions include dealing in riba, alcoholic beverages, gambling (maisir), pork related industries, unethical practices such as prostitution and environmental damaging industries.

Uncertainty (gharar) is another major prohibition in Islamic finance. Uncertainty refers to events that are beyond the normal control of man such as profitability of a certain venture. It is therefore unlawful from the Islamic perspective to guarantee a predetermined amount of profit before the venture or project is concluded as the amount of profit generated is beyond the control of man. Of course effort and controls can be undertaken to ensure profitability but the actual amount cannot be determined at the onset.  

Being just and equitable does not mean at the expense of profits. Viability and profitability should be the main determinant in deciding to enter into a business transaction. Islamic law requires debts to be paid, contracts to be honoured and promises to be kept. However, there is also a need to be compassionate, when the debtor is facing financial distress, it would be the duty of the creditor to understand and not make matters worse. An alternative arrangement must be made to ensure the debt is repaid.

Loans per se are not an Islamic financial instrument. Borrowing and lending money is not encouraged unless in times of distress. Debts or obligations to pay only arise in trade transactions when the payment terms are deferred. The only type of loan recognised under Islamic law is the “benevolent loan” or qardhul hasan. This loan does not carry any interest rate nor does it carry a fixed repayment period. The debtor is expected to repay as soon as he is able and the creditor is not expected to demand repayment. The elements of trust and responsibility play a fundamental role in this transaction.

Money according to Islamic law is not a commodity and therefore has no price and cannot be traded. They are merely an intermediary to facilitate a transaction and therefore have no value on its own. The value of money is how much goods and services it can obtain.  Any exchange of money must involve not merely a trade but a productive economic activity. Any exchange of money with money must be of equal value and on spot basis, otherwise it will result in riba. Islamic economic prohibits hoarding of money. Zakat ensures that money is not kept idle and unproductive. Hoarding money will curtail economic activity and will result in economic hardship.

Islamic finance is all about financial transactions in a just and equitable manner. All parties involved in the transaction are expected to share the gains and bear the risks equitably. Islamic finance is not only for Muslims, it is for everyone who wishes to enter into an equitable financial transaction.