It is difficult to pinpoint the start of Islamic banking, but the consensus is that it took place in Egypt in the 1960s.2 The Egyptian experiment did not last very long, and it was not until the mid 1970s before Islamic banking started to take hold in many Muslim countries. The change can partly be explained by two main factors. First, the 1970s saw two oil price shocks, which led to a massive transfer of wealth from the oil-consuming to the oil-producing countries. The accompanying increase in per capita income led many to seek an alternative to traditional banking that was consistent with Islamic teaching. Second, the second oil shock coincided with the Iranian revolution, which brought about the Khomeini government and the first Islamic republic. Thus began an Islamic revival that spread to other countries and paved the way for more financial institutions of the Islamic type.
This paper looks at Islamic banking as a model of equity finance. Debt financing by conventional banks has experienced crises both in the 1930s and more recently in the 1980s with the savings-and-loan (S & L) and banking crises in the United States. Initially the U.S. answer was to institute deposit insurance in order to eliminate or at least minimize bank runs. However, that has caused both banks and S & Ls to assume more risk at the cost of greater taxpayer exposure because they lacked the incentive to be risk averse. The current U.S. banking model of debt finance together with an implicitly unlimited3 deposit insurance results in the socializing of loss and the privatizing of gain.
While the U.S. banking system represents the debt-finance model, the Japanese financial structure presents an interesting combination of both this model and the Islamic equity-finance structure. The evidence shows that the growth of Japan’s economy in the postwar period was greatly enhanced by the willingness of its banks to both lend money and assume equity stakes in the country’s manufacturing and industrial sector.
The objective of this paper is to analyze the effectiveness of these three models: pure equity finance as in Islamic banking, pure debt finance and a combination of the two. The emphasis of the paper will be on the contention that the Islamic banking model is better able to handle macroeconomic shocks because of its reliance on equity rather than debt. Finally, we examine the issue of debt equity swaps as one of the best alternatives for surplus funds from Islamic banks. We will also attempt to explain why Islamic banks have not been active in this market.
THE PROHIBITION OF INTEREST
Western academics were interested in Islamic banking because of the system’s emphasis on the non-payment of interest. The idea of a financial structure operating without a rate of interest was odd to many accustomed to a fractional-reserve banking system. The non-existence of a “price” of capital4 raises all sorts of questions. How would capital, then, find its most productive use? How can a whole financial system perform without the use of prices? While the non-payment of interest is an important characteristic of the system, there are other important policy implications that affect the conduct of monetary policy and economic growth and development. As Khan and Mirakhor correctly point out,
While the abolition of interest-based transactions is a central tenet of the Islamic economic system, it is by no means an adequate description of the system as a whole5
An alternative capsule characterization of the idea underlying Islamic banking is that money should be based on equity rather than debt. Theoretically, the policy implications of such a financial structure extend to the macroeconomic management of an economy as well as to some aspects of the problem of international debt.
At first, economists who are exposed to Islamic banking often ask, how could a financial system operate without its most important variable? How does an Islamic financial structure allocate funds? More important, how do banks earn a return if they do not charge customers for the use of funds, and how do customers get paid if no interest is used?
The answer is rather simple and straightforward. Under Islamic banking, the answer lies in the profit or loss system (PLS). Instead of guaranteeing a fixed rate of return (interest in the traditional sense), an Islamic bank and the borrower enter into an agreement that clearly spells out the way in which profits or losses are to be shared between the parties from the venture to be financed. The usual relationship between creditor and debtor that we are accustomed to in the West is turned on its head. Expected rates of return from projects or investments are used6 instead of interest rates.
In Islam, money is not capital per se but merely potential capital. It requires the services of someone else, like an entrepreneur, to translate it into productive use. In the Muslim scholar’s view:
the lender has nothing to do with this conversion of money into capital and with using it productively.7
Thus, the idea of getting a return for money deposited in a bank is unacceptable in Islam. Money must be put to productive use, and a risk must be undertaken to justify a return. Furthermore, returns should not be fixed regardless of profits. Thus, guaranteed fixed interest rates, irrespective of the profitability of the bank, is an argument used by Muslim scholars to explain, in part, the bank and S & L failures in the United States.
Interest is forbidden by the Quran as unjust. It is argued that the misfortunes of a fellow human being should not be exploited for gain. Muslim scholars are not satisfied with the theory of interest, as Iqbal and Mirakhor note:
The notion that interest is a reward for saving does not in their [Muslim scholars’] view constitute a moral justification for interest, since such a justification only arises if savings are used for investment to create additional capital and wealth.8
In other words, a person who abstains from consumption and saves should not be rewarded for that act. Unless these savings are turned into productive investment, such a reward is incompatible with the teachings of Islam.
In Islam, the theory preceded the practice of banking. The Quran and Sharia9 essentially contained the parameters within which the practice of Islamic banking can be undertaken. So, contrary to the evolution of Western banking, where the practice preceded the theory, Islamic banking developed in the early 1970s according to strict rules laid down in the Quran and other writings.
Given the emphasis on equity rather than debt, Iqbal and Mirakhor have argued that an interest-free banking (IFB) model would lead to :
more varied and numerous investment projects for which financing is sought; more cautious, selective and perhaps more efficient project selection by the suppliers of funds; and greater involvement of the public in investment and entrepreneurial activities, particularly as private equity markets develop, than in the traditional fixed-interest-based system.10
PRINCIPLES OF ISLAMIC BANKING
There are major differences between an interest-free banking model and the traditional interest-based banking (IBB) model. Under the latter, the level of interest is fixed in advance,11 whereas in the former, the benefits (as well as losses) are shared between the creditor and the borrower according to a formula that reflects their respective levels of participation. Thus, the profit-sharing concept implies an interest in the profitability of the “joint venture” on the part of the creditor (the bank). The emphasis is not on “payment on demand” at set time intervals – as with an interest-based system – but, rather, on the long-term success of the joint venture.
This has considerable implications at the macroeconomic level. First, working capital would theoretically tend to be greater. Second, an economy with an Islamic banking system is less vulnerable to business cycles.12 With such an arrangement, the level of risk is spread between the bank and the entrepreneur in accordance with their respective participation.13
In an IBB model, the creditor (bank) is usually “detached” from the act of investment by the entrepreneur. Should the unfortunate investor experience a sudden cash-flow problem, his operation will likely cease to exist. Muslim scholars argue that such a macroeconomic shock, when repeated across the economy, would not occur under an IFB model. Since banks are part owners of the ventures they help finance, they are not likely to “jump ship” at the first sign of trouble. In other words, an IFB model is better able to absorb shocks than an IBB model. As we shall see later, not everyone agrees.14 Under IFB, the emphasis is on the long run, whereas in an interest-based banking framework, the emphasis is on the short term.
Under a Western-style banking system, the rate of interest is an important variable. It conveys the nature and state of supply and demand; it embodies information concerning the market overall. More important, it helps reduce the search cost for alternative financing schemes.
On the other hand, the profit-sharing mode of finance does not readily provide us with a systematic mechanism by which these profit shares are arrived at. As a result, the search for the most profitable option under IFB will most likely take longer and will probably be costly. Given the limited number of players in different countries, this will persist until the system is generalized to cover a greater number of participants.
Determining the exact mechanism by which profit and loss should be determined is one area where more work needs to be done. Ultimately, with a great number of players in the market, we can argue that in the limit at least, the profit-sharing concept may approach a market solution.
An added cost to the Islamic banks that traditional banks do not have to bear is their obligation to oversee projects in which they are partners. This requires managerial skills and expertise in overseeing different investment projects.15
While John Maynard Keynes would not have supported an IFB system, he did make the case for a low level of interest rates in the long run. Abolishing the rate of interest would essentially diminish the role of savings and investment, the driving force of a Keynesian framework. Nevertheless, it is possible to imagine Keynes supporting IFB, provided the equity (as opposed to interest) system leads to higher capital accumulation and thus employment, which is consistent with the tenets of Islamic economics.
Some disagree. Pryor argues that an IFB model will not stimulate enough savings and investment and thus economic growth. A banking system based on equity, Pryor argued, would not be optimum in terms of generating the needed savings for economic growth.16 The evidence, however, shows that Islamic banks do not lack deposits but rather the right financial instrument to put these funds to work, particularly in the short end of the market.17 Theoretical work18 done in the Islamic economic literature has shown that an economy which uses an IFB system will inherently be more stable. Finally, to those skeptics who argue that the removal of interest would deprive the economic system of a major driving force, one could argue that the expected rate of return could play the same role.19 Nevertheless, while this would work in a formal mathematical model, doubts still persist as to its impact on capital accumulation. In any case, some of the proposals made by an Islamic banking model are not new. In fact, they are similar to those made by Kareken and Simon as well as Friedman.20 Recently, the U.S. treasury’s own banking proposal has been moving in the same direction. Finally, the Japanese banking system also exhibits a striking similarity to that of an IFB model, particularly in its emphasis on “partial” equity finance.
STRUCTURE OF ISLAMIC BANKING
Profits from trade and productive investment are very much encouraged under Islam. As noted earlier, the main objection in Islam is not against the payment of profits but against a fixed predetermined payment – interest or otherwise – that is not a function of the profits and losses incurred in a venture. The only condition is that the entrepreneur faces an uncertain rate of return or profit.
The system puts the emphasis on partnership. An Islamic financial system becomes an equity-based system with no debt. Depositors become shareholders. They are no longer guaranteed the face value of their deposits. They essentially gain or lose depending on the profits and/or losses of the bank. Thus, on the liability side, depositors are nothing more than shareholders; on the asset side, the bank has shares from the joint ventures it helps finance.
A typical example is for an entrepreneur to approach a bank for the financing of a given project. In such an arrangement, the lender, in this case the bank, advances the capital, and the entrepreneur brings his expertise and time to the partnership. The profits are split according to an agreed upon ratio. If the venture incurs a loss or fails, the bank loses the capital spent on the project and the entrepreneur his time and effort. There can be other types of arrangements in which the joint venture can involve multiple partners and different levels of capital investments. Nevertheless, the principle remains the same.
The Sources of Funds
Before an analysis of the Islamic-bank balance sheet is done and compared to that of a traditional bank, we must first examine the most important sources and uses of funds for Islamic banks.21 There are two kinds of deposits: transactions deposits and investment deposits. Transactions deposits are essentially similar to checking accounts in the United States. In both, the Islamic bank and the traditional bank,22 the face value of deposits is guaranteed. Similarly, there are no returns on this type of account, and a service charge may be levied. However, the Islamic bank differs from the traditional bank in the use of these accounts. The money raised through the transaction accounts cannot be used for risky23 ventures. The traditional bank guarantees the face value of deposits through deposit insurance, and the Islamic bank through the restriction imposed on the use of the funds collected through the transaction accounts. In essence, one version of the model as presented in Iqbal and Mirakhor is literally another version of Simon’s proposal of 100-percent reserves.24 The idea is to have a financial institution offer two windows. The window for demand deposits would be required to keep 100-percent reserves; the window for investment deposits could be invested in joint ventures. This version of the model stipulates no reserve requirements for the investment window.
Nienhaus argues otherwise.25 Islamic banking, he says, does not stipulate a system of 100-percent reserves, as in the Chicago school, but rather is a simple fractional reserve system no different from the Western model. He maintains that as long as Islamic banking operates with a reserve requirement of less than 100 percent, there will be money creation; as such an IFB model is no different from an IBB system. While it is true that money creation will occur under the circumstances that Nienhaus outlines, the implications of an Islamic banking system nevertheless still hold.
The second source of funds, investment accounts, is the most important for Islamic banks. Investment accounts are not similar to traditional savings accounts. They do not earn a fixed and/or predetermined rate of return (or interest). Rather, investment accounts are nothing more than shares or equity. Thus, their face value is not guaranteed, unlike saving accounts in the traditional banking system. Holders of these accounts will share the profits and losses with the bank according to the performance of the different joint ventures.
The only guarantee that the holder of an investment account receives is the proportion of the profits and losses that are to be divided between the investor and the bank. This is known as the profit or loss ratio. This ratio is agreed upon in advance and cannot be changed during the life of the contract.
Uses of Funds
In traditional banking, a good part of a bank’s business is in making loans and earning interest on them. However, instead of making loans, an Islamic bank takes an equity position through the credit that it advances. There are two kinds of lending: a one-party joint partnership known as mudarabah and a multiparty joint partnership known as musharaka. The principle is the same under either venture.
The Islamic bank makes funds available for a productive investment to be made by a joint venture between it and one or more investors. But how to convince a bank to part with its investors’ money when the face value of its “loans” (in the Western sense) is not guaranteed? The answer has to do with a simple equity stake position that businesses and banks take every day of the year in a multitude of ventures. Where Islamic banking departs from the traditional fractional-reserve banking is its treatment of risk. Under Islamic banking, risk is transferred to the lender, forcing the latter to finance only those ventures that are sound and to avoid speculative ones.
There are other types of financing such as consumption loans. These are done according to a “hire purchase” formula or a “mark up.” The bank simply buys the product (car, house, etc.) and sells it back to the customer at a profit. The payments are made in installments.
Some have argued that such a system could lead to financial repression. Since the banks must carefully choose their projects, they may disregard all of those that do not guarantee a quick and safe rate of return. The evidence appears to indicate that Islamic banks may become risk averse and more reluctant to engage in equity finance.26
The asset side (uses of funds): the balance sheet of a typical Islamic bank would list the different investments or equity stakes it has in the various projects (loans for a traditional bank). The value of this investment/equity will reflect the general level of economic activity. On the liabilities side (sources of funds), traditional deposits (either demand or savings) become shares and bear more resemblance to an equity position in a mutual fund. Instead of being guaranteed the face value of their deposits, these depositors are essentially shareholders whose returns vary with the profits and losses of the bank. This is no different from an account in a mutual fund whose value is not guaranteed but fluctuates with the market.
With such an arrangement, there is no need for deposit insurance. There is less likelihood of financial panics or runs, since both sides of a bank’s balance sheet would tend to move together. Research in the area of mutual-fund banking, or “non par” banking as Cowen and Kroszner refer to it, comes to the same conclusion.
The run-inducing incentive to withdraw funds at par before the bank renders its liabilities illiquid by closing vanishes with the possibility of nonpar clearing. In effect, there would be a continuous (or, say, daily) “marking to market” of the assets and liabilities.27
Islamic banking, similar to mutual-fund banking, would mark to market the assets and liabilities, thus relieving banking authorities from excessive regulatory oversight. Unlike the savings-and-loan crisis, where figures on the net worth of these financial institutions proved to be meaningless due to the historical cost approach, under Islamic banking (or mutual-fund banking) this would not be the case. Net-worth values would constantly give an adequate read on the health of the financial institution.
A further implication of the profit-loss system is the extent to which Islamic banks can get involved in the projects they finance. Since the financing of any economic or business activity turns into an ownership stake, banks have an incentive to make the joint venture work. They become fully involved in overseeing the project and make sure that the money is spent wisely. Under these arrangements, the whole system turns into an equity-based system and away from the typical debt finance to which traditional banks are accustomed.
One way to grasp the difference between the working of Islamic banks and Western or traditional banks is to look at both the asset side (use of funds) and the liability side (source of funds) of both institutions. On the asset side,28 the Islamic bank would have a certain amount of fixed assets in cash and reserves as well as equity (instead of loans) in the various projects it helped finance. On the liability side of the balance sheet, the bank would have investment accounts profit or loss (PLS) deposits – which are essentially shares. It is important to note that investment accounts are different from savings accounts, since the face value of the former is not guaranteed.
The usual concentration on the quality of bank assets tends to diminish, since the liabilities side of the balance sheet is nothing more than claims on the assets. Since under Islamic banking the face value of the liabilities is only guaranteed for transaction accounts, both sides of the banks’ balance sheet would fluctuate. With competition, the bank must, however, ensure an adequate rate of return (a dividend) for its depositors if it does not want to cause an outflow of deposits, as noted in the example in Kuwait. Under Islamic banking, risk is transferred partly to the lender. This forces the lender to know where the money is spent and how. The bank becomes an active partner whenever it lends money.
There are additional costs associated with such a financial system. Since the emphasis is put on the expected profitability of the venture to be financed rather than the credit worthiness of the business partner, the lender must undertake costly project appraisals, come up with profit-and-loss ratio splits between it and the entrepreneur, and audit ongoing projects all the time. Whereas the traditional bank looks at the credit worthiness and collateral of the borrower, its Islamic counterpart faces a lot more costly underwriting. All of this could effectively lead to financial repression. In fact, what this has done is to skew the distribution of financing by Islamic banks toward short-term “quick kill” types of transactions such as trade finance.
A country whose financial structure exhibits “some” resemblance to an Islamic banking system is Japan. However, the similarity applies only to part of the asset side of the balance sheet. As Kim notes:
banks as a rule provided joint debt equity financing. Moreover, holding other things constant, the level of a bank’s equity holding increased in proportion to financing it supplied the firm and to the riskiness of investment.29
What is interesting in the Japanese banking model is that its structure combines elements of both a traditional banking system and an Islamic one. As noted above, the asset side of the balance sheet in a Japanese bank in part mimics that of an Islamic bank with its equity financing of companies. But it also engages in straight debt financing consistent with the workings of a traditional bank. By engaging in joint debt-equity finance, the Japanese bank is able to address the “agency problem of informational asymmetry.”30 Since the bank is now part owner, it has access to more information on the firm and in turn achieves “efficiency gains in monitoring.”31
Agency problems occur whenever there is a conflict of interest between owners of capital (principal) – the Islamic bank in this case – and agents (or managers) as to the running of a company. Barnea et al. argue,
Agency problems arise because, under the behavioral assumption of self-interest, agents do not invest their best efforts unless such investment is consistent with maximizing their own welfare.32
The joint debt-equity finance is a significant departure from both traditional and Islamic banking systems, combining characteristics of both. The experience of the Japanese economy in the postwar period shows that such a structure can indeed contribute to economic growth.33 Kim notes the following:
The rapid investment-led growth from the 1950s to the early 1970s put a formidable burden on Japan’s financial system. By virtue of the pace of growth, industries’ demand for external funds was large relative to their net worth or collateral, and hence the potential agency costs in issuing debt and equity were commensurately high. In such a setting, the banks, which were the primary conduit of investable funds, were legally sanctioned simultaneously to extend loans and to hold shares of clients’ firms.
The predominant mode of financial contracts during Japan’s rapid growth period thus featured the major lenders also as significant shareholders. Judging from the performance of its economy, such a system appears to have met admirably the task of underwriting Japan’s growth.34
MONETARY POLICY IN AN INTEREST-FREE BANKING SYSTEM
Islamic banking is a fractional reserve system. Nienhaus was essentially correct when he stated that an IFB model is no different from an IBB model in that respect.35 Under an IFB model, the central bank has the power to control high-powered money through varying its own level of deposits with commercial banks.
By purchasing or selling bank shares from commercial banks, the central bank can mimic standard open-market operations. It can also selectively alter the reserve requirement ratios on a variety of liabilities for the purpose of achieving a given monetary target. Finally, not having a discount rate at its disposal, a central bank in an IFB system may be able to control profit-loss ratios and thus achieve the same purpose as a change in the discount rate in a conventional banking model.36
Just as the direct investment rule enacted by the Federal Home Bank Loan Board controls the amount of insured deposits that an S & L could directly invest in risky projects, Islamic central banks can also set a limit on how much of the banks’ funds can be invested in the different types of profit and loss-sharing ventures. The objective of the limit is simply to reduce bank risk by reducing the exposure to a given sector of the economy.
It has been argued that, in the end, an IFB model is not too different from an IBB model. Furthermore, an IFB system, according to Khan,
may well prove to be better suited to adjusting to shocks that result in banking crises and disruption of the payments mechanism of the country. In an equity-based system that excludes predetermined interest rates and does not guarantee the nominal value of deposits, shocks to asset positions are immediately absorbed by changes in the values of shares (deposits) held by the public in the bank. Therefore, the real values of assets and liabilities of banks in such a system would be equal at all points in time.37
Under a traditional banking system, such an automatic adjustment will not occur, and therein lies the potential for financial instability. A case in point is the U.S. savings-and-loan crisis. With a fixed liabilities contract, a shock to the asset side of the saving and loan balance sheet led to a massive failure of many of them. Nienhaus disagrees:
The arguments in favor of the stabilizing qualities are not convincing. They are based on the thesis that Islamic banks could not create money as interest banks do. . . . The conversion to Islamic banking principles does not automatically result in “100-percent money” as suggested by the Chicago economists [Henry Simon and Milton Friedman]. An Islamic banking system is a fractional reserve system and in that respect not different from the traditional system.38
However, Nienhaus agrees that bank failures can be avoided in the context of an IFB model. Moreover, he argues that the shock-absorbing qualities of an IFB model are more “attractive” on a microeconomic than a macroeconomic level. From a purely microeconomic point of view, an IFB system could result in the survival of a bank. However, from a macroeconomic standpoint, the system can result in distributional inequities.
Let us assume that a bank fails. Under an IBB model in the United States, owners would suffer the large share of the loss while depositors would normally be covered by insurance. Under an IFB model, the loss is borne by both owners of capital and depositors since there is no deposit insurance.39 Furthermore, one significant inequity not alluded to in the literature in the case of a bank failure under IFB is the extent to which the burden falls on the poor. This is particularly relevant in LDCs and has recently occurred in Egypt, when an Islamic bank went bankrupt through fraud.
It is true that in a traditional banking system, the Central Bank can have a significant influence on domestic rates of interest through the discount window, open market operations as well as other tools at its disposal. Since in an Islamic banking model, interest rates are replaced by expected rates of returns, these are then determined by the overall economy.40 Mirakhor concurs:
Due to the fact that the return to liabilities will be a direct function of the return to asset portfolios and also because assets are created in response to investment opportunities in the real sector, the return to financing is removed from the cost side and relegated to the profit side, thus allowing the rate of return to financing to be determined by productivity in the real sector. Thus, in the Islamic financial system, it will be the real sector that determines the rate of return to the financial sector rather than the other way around.41
As long as a secondary market exists for these shares (or investment certificates), the market for these instruments would quickly establish a norm. Contrary to the critics who argue that an IFB model may entail a high information cost (due to a lengthy search for the right investment), supporters would argue that an established market can get around that particular constraint.
IMPLICATIONS FOR THE U.S. BANKING CRISIS
There are some interesting implications that flow from the study of Islamic banking to the U.S. banking crisis.42 At a time when the United States has gone through a major S & L crisis as well as a banking crisis, and when the U.S. treasury is struggling to come up with a plausible bank-reform package, it would help to comment on what parts of Islamic banking can be applicable to the United States.
We are not suggesting that the U.S. banking system should suddenly abolish interest rates and turn to an equity-based financial structure overnight. Nevertheless, U.S. banks should be allowed to venture outside their traditional banking business. The emphasis is on the rewriting of the liabilities contract. Once that is allowed to proceed, there will be less pressure on U.S. banks as well as on the deposit insurance fund and finally on U.S. taxpayers.
One approach would be to allow U.S. banks to play a dual role as both banks and mutual funds under one roof. With depositors fully informed, they would have the choice of making standard deposits that are federally insured up to a reasonable limit or open a mutual-fund account which is not. Allowing financial institutions to play this dual role would enlarge the access of mutual-funds accounts to a larger group of the population. It is also more likely for this to occur in a climate of low interest rates. It is much easier for a customer to walk to their local bank and open a mutual fund account with someone they know rather than part with money over the telephone to a total stranger.43
Allowing the banks to play this dual role would limit the exposure of the Federal Deposit Insurance Corporation (FDIC) as more depositors move to the mutual-fund side of the bank. Clearly, the evidence is on the side of mutual funds, which have performed adequately and without deposit insurance. Doing so would at least help minimize the probability of future financial crisis and alleviate the need for an expensive taxpayer bailout.
In 1991, the U.S. Treasury floated its own proposal.44 In essence, the proposal stressed the need to start a two-window approach. A typical bank would offer the customer two choices. The first is a “safe” window, where he/she would open an insured account with little or no return. The second is a “risky” window, where he/ she can open an account that would fetch a higher return but is not insured by the federal government.
Regardless of which banking proposals one looks at, the objective of all of them is to reduce the exposure of the FDIC’s insurance fund. The money lent through the “safe” window would be earmarked for those with an excellent credit risk, while through the other window would be lent money for all sorts of potentially risky but also more lucrative business.
IMPLICATION FOR THE THIRD-WORLD DEBT
In the early 1980s banks began to sell the debt of Less Developed Countries (LDCs) in the secondary market since they were increasingly unable to service their debt obligations. Moreover, the cost of rescheduling or carrying these debts on the banks’ books was increasing. Very soon, a new way was created to alleviate the debt problem, at least marginally. This was done through debt/equity swaps.
Interested banks, multinationals and investors in general can buy an LDC’s debt in the secondary market at a discount and convert it into equity in the debtor’s country.45 Doing so helps to lessen the debt-servicing burden for the LDC and would help the institution that engages in such a transaction – particularly if it also has a stake in that country’s economy. More important, such a transaction is consistent with the goals and objectives of Islamic banking, which calls for an emphasis on the social and developmental benefits of Islamic modes of finance.
Moreover, a case can be made that, had third-world debt been financed partly through an Islamic mode, the present debt crisis would not be as severe. There is a simple reason for this. A good many “loans” would never have been made in the first place. And for those that would have been made, it is clear that an equity finance approach such as Islamic banking would have stayed away from marginal projects. This would have lessened the burden on LDCs, but, more important, prevented these countries from even considering marginal projects. It would also have directed more investments toward export and market-oriented industries instead of the public sector, which bank debt has tended to finance, especially when it came with a government guarantee. A number of Muslim countries could benefit from a debt-equity swap program engineered and facilitated by the leading Islamic banks. These economies suffer from the classical economic ills affecting most LDCs: an overvalued exchange rate, a bloated public sector, a reliance on import substitution as a trade strategy, and a struggling private sector.
The argument behind the approach is the time given to the economies of developing countries to allow them to reform and grow. Also, the LDCs that use equity rather than debt will not have to succumb to the “strict IMF mentality,” where severe adjustment has to take place before a balance-of-payment support program can be agreed upon.
Another secondary benefit relates to a diminished reliance on a country’s level of international reserves. Since most non-oil LDCs rely on hard-currency earnings from the export of a single commodity, their economies become subject to external shocks whenever their term of trade turns against them. In such cases, the LDC has no recourse but to resort to commercial borrowing, which further adds to its debt burden with additional claims on its future output. The ability of Islamic banks to willingly become partners in some of these LDCs diminishes the debt burden – or tax, as some have referred to it – since the LDC shares the profits from a venture, the level of which varies with the LDCs economy. The LDC is not forced to pay an interest and principal, regardless of the performance of its economy.
The concept of profit sharing or Mudharabah has the potential to make some contribution towards the alleviation of international debt. Lending more money to the developing countries only serves to further increase their debt burden. In order for Islamic banks to conform to their guiding philosophy, they should take the lead and start to seriously consider taking equity in various projects in the developing world. Debt-equity swaps is an ideal investment for Islamic banks, since it conforms to the Islamic banking philosophy.46 But it has yet to be embraced.47 To facilitate the task and reduce the risk, a number of them – with perhaps the Islamic Development Bank (IDB)48 taking the lead – could undertake this investment in a syndicated fashion.
Being involved in the supervision or management of a particular investment project could increase the overall cost to banks. However, given the present debt crisis and the deep discounts that prevail in the secondary market, equity finance could reduce the overall risk and help guarantee the success of the joint venture.
Convincing banks in general to join in a profit-sharing scheme will not be an easy task. Risk is often advanced as the prime reason. Furthermore, the prevailing attitude seems to discourage further lending to countries that already cannot repay existing loans. This is precisely the argument in support of a push towards more equity financing of deserving projects. Rescheduling or simply refinancing old debt only serves to delay the inevitable.
Moving away from the classical refinancing of debt into equity participation in new projects would no doubt help to alleviate the debt problem. However, before any success can be registered in this area, Islamic banks need to first address the distribution of investment of financing schemes within each of the countries in which they operate. For example, in Sudan one Islamic bank spends only 5 to 10 percent of its financing on profit-sharing ventures, while 50 to 70 percent is spent on trade finance. The rest appears to be invested in multi-party partnerships.
To be consistent with their own philosophy, Islamic banks need to stress the kinds of investments in manufacturing and industry that add to the value of the sector. Trade finance, which Islamic banks currently prefer, imposes the same burden on developing economies as straight debt finance, since it involves immediate repayment and does not add to the productive capacity of the economy.49
Implementing the proposal outlined in this paper will not be an easy matter. Nevertheless, with some innovative financing techniques, the equity participation idea may, some day, see the light. The impact on global international debt will not be significant, but it is hoped that the technique of equity finance may gain enough acceptance to be practiced by a greater number of banks, Islamic and nonIslamic. The savings and loans crisis as well as the banking crisis have all given fresh impetus to finding new ways to minimize financial crises. It is noteworthy that the proposals advanced so far are not too different, in their objective, from the principles of Islamic banking.
1 For an earlier treatment of this subject, see Mohamed Akacem, “Islamic Economics: Equity Banking as an Approach to Prosperity,” Economic Direction, Summer 1993.
2 It was started by Ahmed El-Naggar, who is recognized as the father of Islamic Banking. El-Naggar’s objective in introducing interest-free banking to Egypt was to link up the often forgotten rural areas with the rest of the economy by establishing financial institutions. This is still a problem in many developing economies. Thus, his overall concern was with rural economic development, as this sector housed the majority of the country’s population. Islamic banks continue to be accused of departing from their primary mission, which is to fund projects consistent with the social and development needs of the country.
3 Because of the “too big to fail” theory. There are numerous examples in the United States where big banks were not allowed to fail because of their size and their ultimate impact on the financial structure and the economy. Thus, the $100,000 deposit insurance has become irrelevant. The current U.S. Treasury proposal is an attempt to address the open-ended exposure of the bank-insurance fund and ultimately, U.S. taxpayers.
4 Baqir Al-Hasani and Abbas Mirakhor, Essays on Iqtisad: The Islamic Approach to Economic Problems (Silver Spring, MD: NUR, 1989), p. 170. Muslim scholars reject the notion that interest is the price of capital, and argue that interest has nothing to do with the productivity of capital. They further maintain that “interest is paid on money, not capital.” But, most important, the interest must be paid “irrespective of capital productivity.” Thus, they conclude that “it is an error of modern theory to treat interest as the price of, or return for, capital.”
5 Mohsin S. Khan and Mirakhor, eds., “The Financial System and Monetary Policy” Theoretical Studies in Islamic Banking and Finance (Houston, TX: IRIS Books, 1986), p. 32.
6 For an elaborate and rigorous theoretical exposition of an Islamic banking model that uses expected rates of return instead of interest rates, see Khan, “Islamic Interest Free Banking,” IMF Staff Papers, Vol. 33, No. 1, March 1986. For a discussion of the general principles and an excellent description of an Islamic structure, see Zubair Iqbal and Mirakhor “Islamic Banking,” IMF Occasional Paper, No. 49, 1987.
7 Iqbal and Mirakhor, ibid., p. 2.
8 Ibid., p. 1.
9 The religious law as found in the Quran and the traditions of the Prophet Muhammad.
10 Iqbal and Mirakhor, op. cit., p. 3.
11 Assuming a fixed rate of interest contract.
12 Khan, op. cit.
13 Some would argue that all risk is transferred to the lender.
14 Volker Nienhaus, “The Impact of Islamic Economics on Banking, Finance and Modern Policy,” paper presented at an international conference on Islamic banking in Geneva Switzerland, 1986.
15 As we shall see later, Japanese banks that engage in joint debt-equity finance have managed to perform adequately, despite this added cost.
16 Khan, op. cit.
17 Many have argued that the lack of an interbank market is one of the most serious deficiencies of an Islamic banking model. Money cannot be lent overnight, for example, for it is difficult to come up with a profit share for such a short time period. Muhammad Uzair, “Some Conceptual and Practical Aspects of Interest-Free Banking,” Studies in Islamic Economics, ed. Khurshid Ahmad (Leicester, U.K.: The Islamic Foundation, 1981) argues otherwise. He claims that “the average annual rate of profitability for the borrowing firm” can be used to estimate a quarterly – or even shorter – rate of profit. Theoretically, it seems, an interbank market under an Islamic banking model is not an impossibility. Although practically it could very well prove to be costly to establish and force banks to carry idle balances at times.
18 Khan and Mirakhor, Theoretical Studies in Islam Banking and Finance (Houston, TX: IRIS Books, 1987).
19 Khan, op. cit.
20 John H. Kareken, “Ensuring Financial Stability,” The Search for Financial Stability (Federal Reserve Bank of San Francisco, 1985); Henry Simon, Economic Policy for a Free Society (University of Chicago Press, 1948); Milton Friedman, A Program for Monetary Stability (NY: Fordham University Press, 1959).
21 Akacem, “Islam and the U.S. Banking Crisis,” Wall Street Journal, May 9, 1991.
22 Throughout the paper, the term traditional bank refers to a non-Islamic bank, one in which interest is featured.
23 Where the probability of incurring a loss is greater than zero.
24 Iqbal and Mirakhor, op. cit., footnote 9. This version has been presented by Mohsin Khan. See also Simon, op. cit.
25 Nienhaus, op. cit.
26 In interview conducted by the author in June of 1987 with the General Manager of the Kuwait Finance House – one of the largest Islamic financial institution in the Middle East – it was found that most of the bank’s activity was in short-term trade finance. When asked why the bank did not commit a larger share of its funds toward projects, the manager argued that he first had to make sure that his depositors-shareholders received adequate dividends every year or else he would lose them.
27 Tyler Cowen and Randall Kroszner, “Mutual Fund Banking: A Market Approach,” The Cato Journal, Vol. 10, No. 1, 1990, p. 227.
28 This is not meant to be a comprehensive list of all the items on the balance sheets of both types of institutions. Rather, we limit ourselves to the most important items that differentiate them.
29 Sun Bae Kim, “The Use of Equity Positions by Banks: The Japanese Evidence,” The Economic Review, Federal Reserve Bank of San Francisco, Fall 1991, p. 41.
30Amir Barnea, Robert A. Haugen and Lemma W. Senbet, Agency Problems and Financial Contracting (Prentice Hall, 1985), p. 38.
31 Kim, op. cit., p. 43.
32 For an elaborate discussion of agency problems, see Barnea et al., op. cit., p. 26. The authors distinguish between the economic theory and the financial theory of agency. The economic theory of agency looks at the relationship between a single provider of capital – the principal – and an agent (manager) who runs the firm/ business. This is notable in that it is this kind of arrangement that is emphasized under an Islamic banking structure where the bank is the sole provider of capital while an entrepreneur invests his time and expertise in the venture. The financial theory of agency looks at the relationship between different providers of capital – equity and bond holders – and the benefit and costs to these groups depending on the type of financing would not occur, so it is limited to equity finance. However, there is the possibility of an Islamic bank being only one of many investors who acquire an equity position in a given venture.
33 Muslim scholars have always argued that an Islamic banking structure is conducive to growth because of its emphasis on project financing through equity. The Japanese model incorporates only part of that, and has shown some positive results. It is too early to conclude that an Islamic banking system that engages in 100-percent equity finance would be as successful because of the limited empirical evidence. Theoretically, at least, the model has been shown to be superior to a traditional banking model.
34 Kim, op. cit., pp. 41-42. Whereas Japanese banks were legally required to engage in joint debt-equity financing, Islamic banks are required to engage in equity (no debt) finance of projects. U.S. banks, on the other hand, are currently limited to hold a maximum of 5 percent of stocks in any one firm. The U.S. banking model appears to represent close to 100-percent debt finance – with all of the noted failures of the 1980s – while the Islamic banking model represents 100-percent equity finance, with the Japanese model combining characteristics of both.
35 Nienhaus, op. cit.
36 It is not quite clear whether the central banking authorities can do this or that it is consistent with Islamic law. Some have argued that it is possible for contracts between banks and depositors not yet signed, but a change in the profit-loss ratio cannot be applied retroactively.
37 Khan, op. cit., p. 19.
38 Nienhaus, op. cit., pp. 12-13.
39 Ibid., argues that “none of the Islamic banking models assume the existence of deposit insurance.” Technically, they should not. As long as depositors are fully aware of the risks of opening investment accounts with an Islamic bank, their account is no different from a mutual-fund account or a privately held portfolio of stocks. These do not and of course should not carry deposit insurance.
40 The Central Bank can, of course, influence to some extent the level and growth of economic activity and thus the expected rates of return from the different ventures/investments (shares).
41 Al-Hasani and Mirakhor, op. cit., p. 176.
42 Akacem, “Islam and the U.S. Banking Crisis.”
43 Not that this has lessened the appeal of owning shares in mutual funds, but enlarging the access through banks would help the smaller and less sophisticated investors who perhaps needs the higher returns to compensate for the lower returns from regular saving accounts and Certificates of Deposit.
44 The U.S. Treasury “Modernizing the Financial System: Recommendations for Safer, More Competitive Banks,” Washington, DC, February 1991.
45 This is usually done at a favorable exchange rate, thus giving the bank/investor a significant profit from the transaction. The size of the profit depends on two things: the size of the discount in the secondary market and the “premium” gained when the conversion is done at a “preferred” exchange rate (close to market) and not the official one (usually overvalued).
46 Akacem, “Islamic Banking and International Debt,” paper presented at the Islamic Banking Conference, Madison Hotel, Washington, DC, September 25-26, 1986; and Sherif Omar Hassan “Islamic Banks and International Development Agencies: Experience, Framework for Enhanced Cooperation,” paper presented at the Islamic Banking Conference, Madison Hotel, Washington, DC, September 25-26, 1986.
47 In order for Islamic banks to succeed in swapping debt for equity in some of the LDCs, these should have a debt-equity swap program in place. Our discussion assumes that most LDCs either do have a program or will not hesitate to start one should the opportunity arise. In any case, the success of such a program could be limited by two factors: First, Islamic banks could refuse to take on additional risk by venturing outside their domestic market and thus continue to behave like a risk averse investor. Second, LDCs may not welcome foreign investment through a debt-equity swap program since it automatically translates into a decrease in the public sector and could engender very high social costs in the short run.
48 The Islamic Development Bank (IDB) is a regional development institution based in Jeddah, Saudi Arabia. Most of the Muslim countries are members of the IDB, with Saudi Arabia holding the majority of capital. The IDB engages in Islamic types of finance and some projects, but a significant amount of activity is also in short-term trade finance.
49 Particularly when it is consumption oriented.
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