RevivingReviving thethe rootsroots ofof IslamicIslamic economicseconomics && financefinance

MahmoudMahmoud AminAmin ElEl--GamalGamal RiceRice UniversityUniversity Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 2 out of 22 of out 2 El-Gamal A. Mahmoud © 2001 16, June Pasadena: uaaa(otpu ae;uulywt rdt,‘jr (leasing), … (cost plus usually with sales; credit), ‘Ijara Murabaha ‘istihsan (juristic preference), ‘istislah (benefit analysis), (benefit ‘istislah preference), (juristic ‘istihsan ’ mental image of Islamic Muslims’ mental image of Islamic Iel L otat:Mdrb (silent partnership). “Ideal” PLS contracts: Mudaraba Short-term substitutes (credit financing): ‘Ijma c Musharaka (partnership), … (partnership), Musharaka cness n ia (analogy) Qiyas and (consensus) finance finance c r (custom), … urf Qur’an and and Qur’an ih(Islamic jurisprudence) Forbidden conventional financial Forbidden Suggest ideal alternative on left Islamic Economists’ ol sRbw loan-based as Ribawi tools writings? Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 3 out of 22 of out 3 El-Gamal A. Mahmoud © 2001 16, June Pasadena:

     

Mudaraba Mudaraba alternative (e.g. various types of “Islamic bonds” via prohibitions factor) and Frustrated the attempts of practitioners Convinced jurists that there is a viable Influenced jurist perceptions of the alternative (e.g. various types of “Islamic bonds” via prohibitions factor) and Frustrated the attempts of practitioners Convinced jurists that there is a viable Influenced jurist perceptions of the     The role of Islamic economists The role of Islamic economists Gharar In fact, it appears that the prohibitions of of prohibition the regarding e.g. myths Gharar In fact, it appears that the prohibitions of of prohibition the regarding e.g. myths           Prohibition of Prohibition of “ “ “ http://www.ruf.rice.edu/~elgamal/files/gharar.pdf http://www.ruf.rice.edu/~elgamal/files/riba.pdf Prohibition of Prohibition of “ “ “ http://www.ruf.rice.edu/~elgamal/files/gharar.pdf http://www.ruf.rice.edu/~elgamal/files/riba.pdf exploitation of the poor return without risk rate of return fixed exploitation of the poor return without risk rate of return fixed , etc.) , etc.) are built are built   Gharar Riba Gharar Riba - - in prudential financial regulations in prudential financial regulations (wisdom/ objective) of certain (wisdom/ objective) of certain enforces enforces ” ” ” ” – – – enforces optimal – enforces optimal what about credit risks and others? what about credit risks and others? what about leasing and credit sales? what about leasing and credit sales? ” ” – – is still possible. is still is still possible. is still “ “ marking to market marking to market   “ “ radical risk radical risk - - Riba Riba sharing sharing (instigating (instigating Riba Riba ” ” “Islamic” “Islamic” ; see ; see ” ” ; see ; see

and and

Ijara Ijara , , Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 4 out of 22 of out 4 El-Gamal A. Mahmoud © 2001 16, June Pasadena:     Jurist views are self Solicited government disagreement with jurist views government Jurist views are self Solicited government disagreement with jurist views government       metallic standard) contract forms classification of modern instruments under known Frequent use of monies with different fatwa #164), but do not permit issuance of multiple Treat different currencies as genera (KFH OIC FA decisions) commodifying Claim that fiat money is not a commodity, while metallic standard) contract forms classification of modern instruments under known Frequent use of monies with different fatwa #164), but do not permit issuance of multiple Treat different currencies as genera (KFH OIC FA decisions) commodifying Claim that fiat money is not a commodity, while

Case study: Government Case study: Government

bonds (a form of money) bonds (a form of money)

fatwas fatwas it by analogy to gold & silver (various it by analogy to gold & silver (various clearly illustrate banker and clearly illustrate banker clearly illustrate banker and clearly illustrate banker   - - contradictory: contradictory: seignorage seignorage   (contrary to bi (contrary to bi , and excessive , and excessive - - Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 5 out of 22 of out 5 El-Gamal A. Mahmoud © 2001 16, June Pasadena:       Rajhi Rajhi Kuwait Finance House & silver exchange ( & silver literature engineering financial from Islamic alternatives listed suggested fiscal deficit; opinion forbidden redemption of bonds in a different currency; Rajhi Rajhi Kuwait Finance House & silver exchange ( & silver literature engineering financial from Islamic alternatives listed suggested fiscal deficit; opinion forbidden redemption of bonds in a different currency; Some interesting solicited Some interesting solicited decision #101: Platinum exempt from gold decision #101: Platinum decision # 12: how can decision #101: Platinum exempt from gold decision #101: Platinum decision # 12: how can Fatwas Fatwas

⌦ ⌦

fatwa fatwa ) ) requirements! requirements! I I # 361: exchange or # 361: exchange or Rajhi Rajhi help with the help with the Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 6 out of 22 of out 6 El-Gamal A. Mahmoud © 2001 16, June Pasadena:   and Moroccan 1989 following joint conference with IRTI and Moroccan 1989 following joint conference with IRTI         they are projects through “PLS” projects through “PLS” Recommend bonds that are tied to specific Bonds that pay [ Zero loans are forbidden bonds Positive coupon forbidden as they are projects through “PLS” projects through “PLS” Recommend bonds that are tied to specific Bonds that pay [ Zero loans are forbidden bonds Positive coupon forbidden as - - , regardless of labels , regardless , regardless of labels , regardless coupon bonds are also forbidden since forbidden coupon bonds are also coupon bonds are also forbidden since forbidden coupon bonds are also Fiqh Fiqh loans loans Acadmy Acadmy loans loans Fatwas Fatwas Awqaf Awqaf sold at a discount sold sold at a discount sold unpromised unpromised that benefit the lender that benefit that benefit the lender that benefit

Ministry: Ministry:

Mudaraba Mudaraba II: II: 6/11/62 6/11/62

] prizes are also ] prizes ] prizes are also ] prizes

ribawi ribawi Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 7 out of 22 of out 7 El-Gamal A. Mahmoud © 2001 16, June Pasadena:           The late Sheikh Dr. Mustafa Al The late Sheikh Dr. Mustafa Al recommends Scathing attack on Dr. that interest = Major contemporary jurists are in consensus All other bonds have the same bearing an interest A treasury Chapra’s regardless of labels “raised doubts about his knowledge and faith” his knowledge “raised doubts about recommends Scathing attack on Dr. that interest = Major contemporary jurists are in consensus All other bonds have the same bearing an interest A treasury Chapra’s regardless of labels “raised doubts about his knowledge and faith” his knowledge “raised doubts about opinion on Treasury Bills (2000) opinion on Treasury Bills (2000) book on a “Just Monetary System” book on a “Just Monetary book on a “Just Monetary System” book on a “Just Monetary - -

bill “cannot be classified” except as bill “cannot bill “cannot be classified” except as bill “cannot

Musharaka Musharaka

Fatwas

Fatwas

riba riba loan loan + reference to Dr. + reference to Dr. Tantawi’s Tantawi’s to the government, to the government,

III III

and and and and

Mudaraba Mudaraba

loan loan

fatwa fatwa - - Zarqa Zarqa status status that that ’ ’ Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 8 out of 22 of out 8 El-Gamal A. Mahmoud © 2001 16, June Pasadena:     of jurists: Economists have adopted the worst traits Economists: worst traits of Jurists have adopted the of jurists: Economists have adopted the worst traits Economists: worst traits of Jurists have adopted the         Absolutism in the definition of “Islamic” function” thought Legalistic “form over then defending them stubbornly problems, Seeking temporary solutions to permanent Goethe’s Faust) like known historical entities money, c.f. (e.g. new inventions Treating Absolutism in the definition of “Islamic” function” thought Legalistic “form over then defending them stubbornly problems, Seeking temporary solutions to permanent Goethe’s Faust) like known historical entities money, c.f. (e.g. new inventions Treating Economists & jurists I Economists & jurists I Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 9 out of 22 of out 9 El-Gamal A. Mahmoud © 2001 16, June Pasadena:         their over contracts, and then criticize Jurists permit Islamic finance industry jurists in the A small number of active Highly segmented Islamic finance markets Islamic finance (the supposed system” writings and the practice of “Islamic economic/financial Rift between their over contracts, and then criticize Jurists permit Islamic finance industry jurists in the A small number of active Highly segmented Islamic finance markets Islamic finance (the supposed system” writings and the practice of “Islamic economic/financial Rift between Paradoxes in Islamic Finance Paradoxes in Islamic Finance - -

usage instead of the PLS “ideal” usage instead of the PLS “ideal”

PLS PLS ideals?) ideals?) Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 10 out of 22 of out 10 El-Gamal A. Mahmoud © 2001 16, June Pasadena: ( ( technologies Financial Different Equity Equity ) ) Model to explain paradoxes Model to explain paradoxes Jurist Preferences / ( Ethical/Islamic ) Juristic-Islamic Secular/Banker Permissibility preferences Frontier ( ( Efficiency Efficiency Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 11 out of 22 of out 11 El-Gamal A. Mahmoud © 2001 16, June Pasadena: ( ( Equity Equity ) ) Economics and Finance Economics and Finance The need for an Islamic The need for an Islamic technology Financial Evolved ( (   Efficiency Efficiency Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 12 out of 22 of out 12 El-Gamal A. Mahmoud © 2001 16, June Pasadena: ( ( Equity Equity cmuiy Islamic Finance “community” Social development-oriented ) ) Islamic Economics ideal (closest permissiblepoint) Modern IslamicFinance Where do we go from here? from go we do Where Common Common Choices Choices ( (   Efficiency Efficiency Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 13 out of 22 of out 13 El-Gamal A. Mahmoud © 2001 16, June Pasadena: ( ( Equity Equity ) ) 1: extreme innovation 0: perfectly safe How far to innovate? ( (   Efficiency Efficiency Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 14 out of 22 of out 14 El-Gamal A. Mahmoud © 2001 16, June Pasadena: Profit(x)=x Credibility(x) Credibility(x)=1- 0.5 0.5 0.5 Model: basic components Model: basic components 0 1 0 1 0 1 0 0 0 200 jurists 50 jurists 10 jurists 0.1 0.1 0.1 0.2 0.2 0.2 B (x|

0.3 0.3 0.3 Profits α

, λ ); ); Degree ofDegree innovation

0.4 0.4 0.4 α

= π 0.5 0.5 0.5

n; λ 0.6 0.6 0.6 =(1-

Credibility

0.7 0.7 0.7 π )n-1; e.g. 0.8 0.8 0.8

0.9 0.9 0.9 π =0.6 1 1 1 Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 15 out of 22 of out 15 El-Gamal A. Mahmoud © 2001 16, June Pasadena: Given one bank Conservative Innovator 3. 2. 1. Given one bank Conservative Innovator 3. 2. 1. Solve for Solve for Challenge Innovate Share Challenge Innovate Share ’ ’ s profits: s profits: monopoly profits, monopoly profits, Cournot Cournot ’ ’ s profits: s profits: further, or further, or ’ ’ : discredit first bank to take his business : discredit first bank to take his business s level of innovation, second bank can: s level of innovation, second bank can:

Competition Competition π 1 1 2 1 2 112 ( )) ( )(1 ( ) , (

x π - - Nash equilibrium (fixed point) 1 2 212 Nash equilibrium (fixed point) xxx Fx xx ,) (, xx xx =+−− = 2()() −− 1()) ( (1 xFx Fx 2()() − −− Fx 1()) ( (1 12 F − 1 xFx Fx 12 2 2 2 Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 16 out of 22 of out 16 El-Gamal A. Mahmoud © 2001 16, June Pasadena: The Economics of Jurisprudence The Economics of Jurisprudence Degree of innovation 0.45 0.55 0.65 0.5 0.6 0.7 0 ubro uit Number of jurists Number of jurists v v s nnov on io t va o n in 's ive t Monoopolist's innovation rva e s n o C Innovator's innovation 50 100 0.21 0.22 0.23 0.24 0.25 0.26 0.2 0 1/2 Monopolist's profits Conservative'sprofits Innovator's profits 50 100

Profits Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 17 out of 22 of out 17 El-Gamal A. Mahmoud © 2001 16, June Pasadena:           (  If jurists cared only about perceived jurist Despite the rhetoric, banks benefit from involved: As more jurists get (  If jurists cared only about perceived jurist Despite the rhetoric, banks benefit from involved: As more jurists get proximity to conventional finance proximity to conventional finance Explaining the paradoxes Explaining the paradoxes Then, beyond some point, more innovation At first, the industry sees more conservatism Then, beyond some point, more innovation At first, the industry sees more conservatism - - supported market segmentation supported market segmentation : : quit at minimum “innovation” quit at minimum “innovation” quit at minimum “innovation” quit at minimum “innovation” ) ) Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 18 out of 22 of out 18 El-Gamal A. Mahmoud © 2001 16, June Pasadena:         historical jurisprudence based on outdated thought historical jurisprudence for less apologetic more careful and we be Can Islamic Legal Texts? conclusions regarding the understanding of Can we overcome the urge to come hasty economics and financial products? Can we overcome outdated suspicions of “western” as a “certainty” (virtual consensus)? treated what is now Can we recognize as “probable” historical jurisprudence based on outdated thought historical jurisprudence for less apologetic more careful and we be Can Islamic Legal Texts? conclusions regarding the understanding of Can we overcome the urge to come hasty economics and financial products? Can we overcome outdated suspicions of “western” as a “certainty” (virtual consensus)? treated what is now Can we recognize as “probable” Outstanding questions Outstanding questions Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 19 out of 22 of out 19 El-Gamal A. Mahmoud © 2001 16, June Pasadena: Opportunity: Islamic & conventional banking convergence? Opportunity: Islamic & conventional banking convergence? 30 40 50 60 70 80 90 Jan70 ore eea eev ttsia ees H.8, Feb. 2, 2001 Source: Federal Reserve Statistical Release – Assets and liabilities decomposition for U.S. commercial liabilities decomposition Assets and banks Non-real estate loans as a percentage total of assets as a percentage Non-real estate loans Jan75 Jan80 Deposits as a Deposits total liabilities percentage of Jan85 Jan90 Jan95 Jan00 Jan05 Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 20 out of 22 of out 20 El-Gamal A. Mahmoud © 2001 16, June Pasadena: Opportunity: Islamic & conventional banking convergence? Opportunity: Islamic & conventional banking convergence? 40 45 50 55 60 65 70 75 80 85 90 1990 Income and expense decomposition for U.S. commercial banks 1991 Gross interest expense as a percentage of total expense Source: Federal Reserve Bulletin, June 2000 total income interestof incomeGross as a percentage 1992 1993 1994 1995 1996 1997 1998 1999 Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 21 out of 22 of out 21 El-Gamal A. Mahmoud © 2001 16, June Pasadena: Opportunity: Islamic & conventional banking convergence? Opportunity: Islamic & conventional banking convergence? ore akPoiaiiy iaca ttmnso ak,OC,1999. Source: Bank Profitability: Financial Statements of Banks, OECD, 10 20 30 40 50 60 1988 0 of gross incomecommercialof of banks Net non-interest income as a percentage 1989 1990 1991 1992 1993 1994 1995 U.S.A. U.S.A. U.K. Switzerland Luxembourg Germany France Canada Belgium 1996 Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 22 out of 22 of out 22 El-Gamal A. Mahmoud © 2001 16, June Pasadena:     Can economists adopt the best traits of jurists Can jurists adopt the best traits of economists Can economists adopt the best traits of jurists Can jurists adopt the best traits of economists         champion political/ideological causes Consider overall social costs and benefits, rather than Think about function rather than form & label the “closest in ideology/rhetoric” Consult with “the best in the business”, rather than human Be skeptical about their “models”; recall that all champion political/ideological causes Consider overall social costs and benefits, rather than Think about function rather than form & label the “closest in ideology/rhetoric” Consult with “the best in the business”, rather than human Be skeptical about their “models”; recall that all Economists & Jurists II Economists & Jurists II - - judgment judgment - - based “knowledge” is wrong based “knowledge” is wrong