Shariahnomics — Islamic finance

Posted in economics, institutions, micro by jrahman on February 5, 2013

In the last half decade of Hosni Mubarak’s rule, the Egyptian economy grew by healthy 5-7% a year.  Economic growth dipped to less than 2% a year after the revolution.  Currently, Egypt is on the brink of economic meltdown, and is negotiating an IMF rescue package.  The IMF package will probably involve tax reforms, privatisation, trade liberalisation, removal of subsidies, you know, the standard Washington Consensus neoliberalism.  The Muslim Brotherhood run government of Egypt does not particularly want to do any of these things.  As I speculated over a year ago, economic problems are giving anti-Brotherhood factions a political opening.

But this post is not about Egypt.

Islam is the solution — the Muslim Brotherhood used to say.  It will be interesting to see whether someone issues a fatwa declaring the IMF package as ‘Islamic’ or Shariah-consistent.  But as far as I can tell, the two things most commonly associated with Islamic economics — zakat and Islamic finance — have very little to say about Egypt’s current problems.

I’ll do a separate post or two about the origin of Islamic economics.  And there will be a post on zakat.  Over the fold, some thoughts on Islamic finance from the perspective of a mainstream economist (who may or may not be a believer).


Believers! Do not live on interest, doubled and redoubled!

– The Quran, Chapter 3: Verse 130.

This is the usual reference to the prohibition of interest — riba — in Islam.  There is a debate about what exactly is covered in riba.  I don’t speak Arabic, and in no position to judge whether interest here refers to the ordinary English meaning of the word, or some rate of interest that is above and beyond what one might consider equitable (never mind how ‘equitable’ is defined).

In practice, the so-called Islamic banks have devised debt contracts that serve the same purpose as interest — compensating the lender for the time value of money.  Murabaha is one such way.  Suppose you want to borrow $100,000 from the bank to buy some machines for your business (or expand your kitchen or whatever).  With a normal bank, you would repay the bank, say, $105,000 — the $5,000 being interest (at 5%).  With murabaha, you buy the machine from the bank at $105,000, which you pay in a year’s time.  This is apparently halal.

The logic here is that the $5,000 is not interest, which is a compensation for the bank not having the money for a year.  Rather, it’s a compensation for the risk the bank is taking in buying the machine for you.

That risk-sharing is permissible gives rise to the concepts of mudaraba and musharaka.  Here, instead of the bank lending you the money — whether for normal interest or for murabaha — buys shares in your business.  If your business does well because of the machine, the bank gets back a share of the profit.  If the machine turns out to be useless, the bank loses money.  The bank is an investor, not a lender.

That is, we are talking equity finance, not debt finance.

Of course, this can be tricky in practice.  The bank is likely to know less about your business than you do — so there is a risk that you can take the bank for a ride.  Plus, if I deposit my saving in this bank, I am deprived of a guaranteed return on my saving — through the bank, I too have taken a risk.

But then again, if the last decade has taught us anything, it is that banks are not particularly good at pricing risks anyway.  Isn’t it better that we all share the risk in a more transparent manner, which is what the risk sharing aspect of Islamic banking delivers.  At least theoretically, risk sharing will lessen the probability of another subprime crisis.



9 Responses

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  1. Diganta said, on February 6, 2013 at 3:34 am

    “if the last decade has taught us anything, it is that banks are not particularly good at pricing risks anyway. ” – That was precisely one of the fundamental problems in US housing bubble. Most of the banking personnel had little clue over how the housing bubble is inflating.

  2. Diganta said, on February 6, 2013 at 3:41 am

    Now the flip-side of the same would be lack of finances for a start-up. If there are none to invest in a high-risk entity 🙂 it’s definitely not pro-growth.

  3. shoronarthhi said, on February 6, 2013 at 10:10 pm

    Big quibble about the first paragraph: the current crisis is Egypt isn’t about economic problems – though it should be.

    On Islamic finance – for a deep, economically-informed book, read El Gamal’s book on the topic – highly critical of the current state of the industry, but with a number of good ideas about the direction it should take.

  4. jrahman said, on February 8, 2013 at 5:46 am

    Diganta, theoretically there is nothing about equity finance that hinders start-up finances. There are, however, other features of Islamic economic institutions that harmed growth. I’ll post about these later.

    Shoronarthhi, clumsy framing on my part — Egypt’s current crisis is not about economic problems, but coming out of the crisis, liberals can use economic issues to their advantage. Re: El Gamal’s book, reference please.

  5. Niels Christensen said, on February 10, 2013 at 12:06 am

    Just a couple of comments.
    The idea that the bank converts lending to shares are not unknown in the capitalist world/non sharia- ( or that banks own shares in companies) but it’s worth noting that in many countries ownership is strongly regulated, because the structure of a banks assets is regulated. And bank ownership looks like a ‘nice’ idea, but in practice it can be very complicated and not without problems, simply because risk sharing can very ambiguous
    Secondly the size of the ‘compensation’ money has to be measured against something,(risks among other things) , and f there is a market where the lender has more possibilities how does the lender compare.
    it will be a fair guess that it’s compared against some kind of interest rate as long as most of the economy is based on interests.

    • Diganta said, on February 11, 2013 at 12:52 pm

      That’s what I wondered about because Venture capitalists share ownership for investing in a start-up. So, sharing is an idea which capitalism always had …

  6. jrahman said, on February 13, 2013 at 11:51 am

    Shoronarthhi, thanks. Very useful. Niels, agree with your observations.

  7. […] discussed the theory of Islamic finance in the last post on this subject.  Here is a nice summary of the difference between Islamic and […]

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