What Islamic finance can offer
Written by Edward Hadas, Economics Editor at Reuters Breakingviews
The Islamic approach to finance was once the most advanced in the world. The period of pre-eminence ended six or seven centuries ago, but the religion’s fundamental insights into the field could help form a financial system suitable for the 21st century.
From the beginning, Muslim teaching took a religious view of commercial relations and responsibilities. There are a few injunctions in the Koran and far more in the teachings traditionally attributed to Mohammad. I am not an expert, but the basic ideas seem clear enough: merchants should be fair, risks should be moderate and understood, and God condemns all rapacious financial practices.
During the first centuries of Islam, Muslims became great traders, providing an economic bridge between Asia and Europe. Europeans adopted and then further developed the Islamic techniques of providing credit and of sharing responsibilities, risks and rewards. Christian thinkers continued the Islamic debate over what was fair and just, and church authorities copied the Islamic teachers’ practices, ruling on the legitimacy of transactions, and exhorting merchants and investors to restrain their greed.
Of course, those exhortations often fell on deaf ears. However, until well after the start of the Industrial Revolution few Muslims or Christians would have argued with the notions that trade should be just and finance should serve the common good.
Indeed, much of the Western world’s financial system looked more Islamic than hard-edged capitalist until about 30 years ago. The vast majority of banking assets in Europe and a substantial minority in the United States were held by institutions which did not have profit-seeking shareholders. Rather, these mutuals, thrifts, savings banks, French caisses, co-operative banks, church banks and credit unions aimed first of all to serve their members and their communities. Insurance was also largely a mutual business.
Then came the era of demutualisation, when selfish profit-seeking became the norm. In the new era, the worst possible aspects of a financial system – greed, exploitation of the ignorant and excessive risk-taking – were allowed to run wild. Bankers became ridiculously rich while debts expanded at an unsustainable pace.
The free rein of financial selfishness ended in tears, as any traditional Islamic (or Christian) teacher would have predicted. Unfortunately, contemporary Islamic efforts in finance were too influenced by the free-market model. Jurists and bankers worked together to design instruments, from mortgages to hedge funds, which would be both compliant with the jurists’ interpretation of sharia (Islamic law) and economically identical to conventional financial products.
This finance of “sharia arbitrage”, as Mahmoud A. El-Gamal of Rice University calls it in his book “Islamic Finance”, is largely based on a narrow understanding of two prohibited practices: riba and gharar, usually translated as interest and risk. For example, jurists declare that riba is avoided if a loan can be portrayed as a sale at one price and a gradual repayment at a higher price, even if the gap between the two equates to an interest rate of 100 percent. El-Gamal is highly critical of this sharp practice.
I am not competent to opine on Islamic law, but the current approach to Islamic finance certainly misses what is most valuable for non-Muslims about riba and gharar: the way they fuse ethics with practice.
If El-Gamal is right, riba is best understood as unjust financial advantage, akin to certain legal definitions of usury. Following that definition, there is no riba when lenders and borrowers justly share the wealth created by a loan. Loans, which have fixed interest rates and must be repaid, can be free of riba. Equity investments (common shares) are usually even more just. The forced repayment of principal on loans at maturity can be unjust on the borrower; that possibility is avoided with the permanent capital of equity. Also, while fixed interest payments are sometimes unjustly low or high, shares’ variable dividends can reflect changing circumstances.
Finance always involves commitments in an uncertain world, so risk can never be avoided completely. Gharar, according to El-Gamal, properly refers to unnecessary or inappropriate risks, as exemplified in the classical example of selling the pearl diver’s future catch before the actual dive. Gharar seems to take in all unnecessary speculation. The prohibition is just, because financial gains should come from providing something of economic value, not from luck or from outwitting a trading partner about the risks of a bet.
The excesses and dishonesty which led up to the financial crisis show that the current system has lost its moral compass, but a new one cannot be plucked straight out of some previous era. Traditional banks and insurers would be too small and unsophisticated for today’s global economy.
Still, we can renew the best ideas of the past. Between them, riba or gharar account for most of the objectionable practices of contemporary finance. They should be banned.
This blog post is used with kind permission of the author and first appeared on blogs.reuters.com.
About the author
Edward Hadas writes about macroeconomics, markets and metals for Reuters Breakingviews. Before becoming a journalist, he worked for 20 years as an equity analyst in Europe and the US. His book, “Human Good, Economic Evils: A Moral Approach to the Dismal Science” is published by ISI Books in Wilmington, Delaware. He has also written a course-book about political philosophy for the Maryvale Institute in Birmingham. Edward has degrees from Columbia University, Wadham College, Oxford and the State University of New York at Binghamton. He has a website, edwardhadas.com.