Interest Free Banking

pakfin...I am by no means a scholar of Islam or have any training in Islamic banking but I think what Islam wanted to prohibit was a kind of loan sharking which seemed to have plagued societies in those days. I am not a big buyer of banks taking equity stakes in either large well established corporations or new ventures due to inherant moral hazards associated with the practice.

#99 by yusafkhan on December 14, 2002 4:20pm PT
Interest is rent:
Yusaf you are right. It is a similar concept. The first thing to realise here is that capital has value and that no one would be willing to give up that value without some sort of return. The propagonists of Islamic Banking have not been able to come up with too many real modes of Islamic Financing (other than Musharika and Modaraba). What most of these institutions are doing is to call interest profit or commission.

Interest is rent:
Money is an asset similar to a car or a house. When I rent out my house I recieve the rent while the renters get the opportunity to use the house, my asset. Similarly, it should be equally fine for me to lend out my cash savings, another asset, and receive rent which is the interest. Why should renting my home be allowed and renting my cash not? they are afterall the two faces of the same coin. I would go a step further to say that the market for lending my cash, or borrowing cash, is alot more liquid, well regulated and transparent than renting a house, which in financial terms is kind of an OTC (over the counter) contract.

Asfand,

While your intensions may be noble, your concepts are misplaced.

The reason why I say this is because, rent is not exogenous, but in fact it is based on things like cost of property and financing and the perception of future price movement.

A person who rents a place is not looking for a long term committment on the property and which is why he may pay an amount that is different from what it should be on the basis of cost of carry.

I remember paying 10% of the property price in Canada because people were thinking that the prices may fall further and did not want to make a financial committment.

But in a mortgage where I am willing to make a financial commitment why should I pay for the, leave the property after lease expiry option.

I think a major problem for the Islamic Financers is that they have been unable to reconcile to the risk reward matrix. They have been unable to understand what drives the pricing of financial instruments and what motivates individuals to transact. If they were to understand that then they would be able to comprehend that the formal financial sector is most Islamic, i.e. it is fair to both the borrowers and lenders without the transaction being disguised to fool people as is being done by large Global Banks.

I would like to add a few concepts to this discussion.

1) If we have hyper inflation like what we used to have in Turkey 120% per annum or 1% every 3 days, how does one go about pricing goods in Turkey versus in Japan where there is a deflation of 3% per annum. Conceptually should deferred purchase have the same amount of profit, else it become profiteering.

2) The currency is printed by the Central Bank and is lent to the government who runs a budget deficit so that the money in circulation increases. Assuming that we start a new country, the Central Bank would not simply hand us the money by itself or in exchange for goods for it does not have any mechanism to store goods (except maybe gold even that Central Banks are shedding). So the point being if money is issued only with the full faith and obligation of the Government only, this would normally give rise to inflation which is why to balance the loss in purchasing power the lender demands interest (otherwise he would invest it in real assets whose nominal price would increase with inflation).

3) Islamic Banking specialist start investment banking not at the stage of issuance of money but somehow think that investors and borrowers should engage in this activity. They cannot reconcile the alternatives available to them and the risks involved in the process. In an hyper inflationary environment if I have excess cash for 1 week can I take a risk on a company involved in an economic activity. No because that company is engaging in a long term activity and whose value would be driven by the level of customer satisfaction it has been able to develop that would lead to greater profits in the future. Profits are not merely the amount of money made in the past but what can be made in the future based on the activity today.

Short term investments should give us small return in short term horizon while long term investments should be evaluated on the basis of future cash flows.

I hope I have not confused the issue.

Re: #94 by tahmed32 [``...Junaid is my old classmate from Government College Lahore. Small world. ...``]

It is a small world, Ahmed sahib, and its getting smaller. Glad to know that you are also a fellow Lahori. They say you can get the boy out of Lahore, but you cannot get Lahore out of the boy. I cannot say about anyone else, but it certainly hold true for this humble servant of yours.

As for Rabbani sahib, I have only had the pleasure of meeting him once at a gathering in the mid-1990s. He wouldn`t possibly remember me. I hear about him simply because I have the honor of sharing his last name and since he is a prominent member of the community in the New York area the subject comes up during conversations.

...SR

Re: #93:

The email is, without any space or other characters, myfullname at yahoo dot com. Always glad to hear from the friends of Chowk. Please drop a note anytime.

...SR

pakfin #93 You may receive enlightenment directly from guru SR. In return, please send a small donation (interest free) to me.
SR #92 Junaid is my old classmate from Government College Lahore. Small world.

SR I would like to get your views on the economy in some detail. How can I get in touch with you? Is there an email address that I may use?

Re: #91 by pakfin [``... are you the same Rabbani who worked for Citibank in Treasury in New York?...``]

No sir, that is Junaid Rabbani. He is a successful finance executive, whereas I am not even an ordinary bank peon. Junaid has moved from Citi. For a while he went to Aetna but recently he`s gone private (asset management).

...SR

#88 by zeemax . Let us look at the fallacy in this argument.

Consider a morabaha transaction where an individual is getting a loan to buy a house.

The individual sells two airconditioners to the bank for Rs. 1,000,000 and then buys them back for Rs. 2,500,000 immediately. This amount of Rs. 2,500,000 is then repayable to the bank in equal monthly installments over a period of say 20 years. The repurchase price is fixed by the financial institution based on the internal rate of return that it wants on the loan. The individual either sells property that he/she does not own or property that he/she does own at an inflated price.

Is this Islamic banking?

SR are you the same Rabbani who worked for Citibank in Treasury in New York?

zeemax #88 They say that someone who knows WHAT is to be done is a good worker. However, the person who knows WHY something is being done is his boss. The trouble I see in Islamic Banking is that people have their own interpretations of WHAT is to be done, and I have yet to read one sentence in any discussion on WHY the Quran is against Riba. The reason the WHY does not come up is because the basic thrust of the Quran is counter to the ethos of ``Islam`` as it exists in practice among fervent muslims around the world.
We must change the way we view what Islam is all about before we can talk about Islamic Banking. And when we do, we will realize that Islamic Banking is first and foremost about being reliable and customer-oriented. In other words, doing what the best among commercial banks (and this does NOT include nationalized banks in Pakistan) have been doing all along all over the world.

Well, I think I made it abundantly clear in my post #84 that the Islamic mode of Finance does not contemplate on eliminating a reward or `rent` for capital, but it does abhor `interest` as a reward for capital. The reward in, say Morabaha deals, comes from re-invoicing the purchased goods. In this mode there is no concept of borrowing, or collateral. Only purchase and re-sale. In these deals the only collateral is over the cash flows emanating from the goods financed, and not over the goods themselves. The title of the goods passes from the financier to the borrower immediately once the deal is consummated and the goods become freehold. This is because pledging goods for `Rehan` or in other words hawking one`s property is forbidden.

The problem arises when one has to decide on the re-invoiced price. What should it be? tahmed32 is right in saying that it may be hypocrisy because so far it is calculated based upon the cost of funds for the tenor, plus administrative cost plus profit. However one important fact remains. The goods are the possession of the borrower and not mortgaged. It`s upto the lender to assess the future cash flows and place a lien over them. That`s permitted as it’s an investment in future cash flows rather than usurping someone`s property towards a fixed return by the benefit of possession of capital. In my opinion that`s the theory behind it all and must not be rejected outright. It`s also an important distinction and goes a long way towards the expertise and monitoring capabilities of the lenders as against collateral based fixed-return lending.

The main problem with Islamic Mode of Finance is not even the needs of risk-averse depositors. This could be corrected by a central provident fund, funded from zakat proceeds to insure any needy person getting burnt in the process. The National Savings Schemes are right now being funded from fiscal resources. No one knows where the colossal zakat deductions go. Those resources could be easily replaced with the zakat fund.

The main problem is State Funding and Monetary Policy. How does one conduct a monetary policy without T-Bills ? And how does one fund Budgetary Deficits without Bank/Non-bank borrowing ?

There are answers to the above as well through securitizations of State Assets and lease-back through Special Purpose Vehicles (SPVs) which are provided for in Islamic Mode through `Ijara`. A Capital lease is Ijara while a Finance Lease is not permitted. Securitization of say Tarbela Dam would be a Capital lease. Car finance is a Finance lease.

Therefore, there are modern solutions to the `7th Century` ideas as my good friend GhalibZaman stated. However, Islamic Mode of Finance is neither Hypocrisy nor nonsense. Its a very serious counter-approach to finance and banking as we know it..

Regards.

Zeemax: Here is a simple test of Islamic Banking - Would you be willing to open a Bank that pays zero interest to its depositors and asks zero interest from its borrowers?
If yes, then please advise when you are open for business and I will be your first borrower.
More seriously, whatever way I look at it Islamic Banking is either hypocrisy (where interest is called many different names, and equity participation is called a ``loan``) or else a non-starter (as you say, you dont contribute resources to economic activity without charging a ``rent`` of some kind). If the proponents of Islamic Banking were really trying to ``follow instructions`` as they understand it, they would give loans plain and simple without interest. The problem with most fervent muslims is that they are afraid to use their own minds, and follow what they have been told like sheep.

Zeemax:

Thank you for this very timely input. Would you please participate and write something about how the Islamic mode of Finance ( I like the ring of it) is working on a practical level and how are present-day ``educated`` ones in MBA & Banking Institutes coping with the shock of ``7th`` century modernity.

Under our english-based education ( read: Mind Colonisation) system one is trained specifically never to use one own mind. The ability to ape & parrot in food, dress, and alien-accent is considered the highest achievement. The result is for all to see. We have Pleaders intead of Leaders and those who seek salvation by offerring themselves to be enslaved by the remote-controllers.

Please stay in touch. You know how :)