RevivingReviving thethe rootsroots ofof IslamicIslamic economicseconomics && financefinance MahmoudMahmoud AminAmin ElEl--GamalGamal RiceRice UniversityUniversity Muslims’Muslims’ mentalmental imageimage ofof IslamicIslamic financefinance Qur’an and Sunnah ‘Ijmac (consensus) and Qiyas (analogy) Islamic Economists’ writings? ‘istihsan (juristic preference), ‘istislah (benefit analysis), curf (custom), … Fiqh (Islamic jurisprudence) “Ideal” PLS contracts: Mudaraba (silent partnership). Musharaka (partnership), … Forbidden conventional financial tools as Ribawi loan-based Short-term substitutes (credit financing): Suggest ideal alternative on left Murabaha (cost plus sales; usually with credit), ‘Ijara (leasing), … Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 2 out of 22 TheThe rolerole ofof IslamicIslamic economistseconomists Influenced jurist perceptions of the (instigating factor) and (wisdom/ objective) of certain prohibitions e.g. myths regarding the prohibition of Riba “fixed rate of return” – what about leasing and credit sales? “return without risk” – what about credit risks and others? “exploitation of the poor” – is still possible. In fact, it appears that the prohibitions of Riba and Gharar are built-in prudential financial regulations Prohibition of Riba enforces “marking to market”; see http://www.ruf.rice.edu/~elgamal/files/riba.pdf Prohibition of Gharar enforces optimal “risk-sharing”; see http://www.ruf.rice.edu/~elgamal/files/gharar.pdf Convinced jurists that there is a viable radical “Islamic” alternative (e.g. various types of “Islamic bonds” via Ijara, Mudaraba, etc.) Pasadena: Frustrated June 16, 2001 the attempts © Mahmoud of practitioners A. El-Gamal 3 out of 22 CaseCase study:study: GovernmentGovernment bondsbonds (a(a formform ofof money)money) SolicitedSolicited fatwasfatwas clearlyclearly illustrateillustrate bankerbanker andand governmentgovernment disagreementdisagreement withwith juristjurist viewsviews JuristJurist viewsviews areare selfself--contradictory:contradictory: Claim that fiat money is not a commodity, while commodifying it by analogy to gold & silver (various OIC FA decisions) Treat different currencies as different genera (KFH fatwa #164), but do not permit issuance of multiple monies with different seignorage (contrary to bi- metallic standard) Frequent use of , and excessive classification of modern instruments under known contract forms Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 4 out of 22 SomeSome interestinginteresting solicitedsolicited FatwasFatwas II KuwaitKuwait FinanceFinance HouseHouse fatwafatwa ## 361:361: exchangeexchange oror redemptionredemption ofof bondsbonds inin aa differentdifferent currency;currency; forbiddenforbidden RajhiRajhi decisiondecision ## 12:12: howhow cancan RajhiRajhi helphelp withwith thethe fiscalfiscal deficit;deficit; opinionopinion listedlisted suggestedsuggested alternativesalternatives fromfrom IslamicIslamic financialfinancial engineeringengineering literatureliterature RajhiRajhi decisiondecision #101:#101: PlatinumPlatinum exemptexempt fromfrom goldgold && silversilver exchangeexchange ((⌦⌦)) requirements!requirements! Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 5 out of 22 FatwasFatwas II:II: FiqhFiqh AcadmyAcadmy 6/11/626/11/62 19891989 followingfollowing jointjoint conferenceconference withwith IRTIIRTI andand MoroccanMoroccan AwqafAwqaf Ministry:Ministry: PositivePositive couponcoupon bondsbonds areare forbiddenforbidden ribawiribawi loansloans,, regardlessregardless ofof labelslabels ZeroZero--couponcoupon bondsbonds areare alsoalso forbiddenforbidden sincesince theythey areare loansloans soldsold atat aa discountdiscount BondsBonds thatthat paypay [[unpromisedunpromised]] prizesprizes areare alsoalso forbiddenforbidden asas loansloans thatthat benefitbenefit thethe lenderlender RecommendRecommend bondsbonds thatthat areare tiedtied toto specificspecific projectsprojects throughthrough “PLS”“PLS” MudarabaMudaraba Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 6 out of 22 FatwasFatwas IIIIII TheThe latelate SheikhSheikh Dr.Dr. MustafaMustafa AlAl--ZarqaZarqa’’ opinionopinion onon TreasuryTreasury BillsBills (2000)(2000) AA treasurytreasury--billbill “cannot“cannot bebe classified”classified” exceptexcept asas anan interestinterest bearingbearing loanloan toto thethe government,government, regardlessregardless ofof labelslabels AllAll otherother bondsbonds havehave thethe samesame loanloan statusstatus MajorMajor contemporarycontemporary juristsjurists areare inin consensusconsensus thatthat interestinterest == ribariba ++ referencereference toto Dr.Dr. Chapra’sChapra’s bookbook onon aa “Just“Just MonetaryMonetary System”System” ScathingScathing attackattack onon Dr.Dr. Tantawi’sTantawi’s fatwafatwa thatthat “raised“raised doubtsdoubts aboutabout hishis knowledgeknowledge andand faith”faith” recommendsrecommends MusharakaMusharaka andand MudarabaMudaraba Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 7 out of 22 EconomistsEconomists && juristsjurists II JuristsJurists havehave adoptedadopted thethe worstworst traitstraits ofof Economists:Economists: TreatingTreating newnew inventionsinventions (e.g.(e.g. money,money, c.f.c.f. Goethe’sGoethe’s Faust)Faust) likelike knownknown historicalhistorical entitiesentities SeekingSeeking temporarytemporary solutionssolutions toto permanentpermanent problems,problems, thenthen defendingdefending themthem stubbornlystubbornly EconomistsEconomists havehave adoptedadopted thethe worstworst traitstraits ofof jurists:jurists: LegalisticLegalistic “form“form overover function”function” thoughtthought AbsolutismAbsolutism inin thethe definitiondefinition ofof “Islamic”“Islamic” Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 8 out of 22 ParadoxesParadoxes inin IslamicIslamic FinanceFinance RiftRift betweenbetween “Islamic“Islamic economic/financialeconomic/financial system”system” writingswritings andand thethe practicepractice ofof IslamicIslamic financefinance (the(the supposedsupposed PLSPLS ideals?)ideals?) HighlyHighly segmentedsegmented IslamicIslamic financefinance marketsmarkets AA smallsmall numbernumber ofof activeactive juristsjurists inin thethe IslamicIslamic financefinance industryindustry JuristsJurists permitpermit contracts,contracts, andand thenthen criticizecriticize theirtheir overover--usageusage insteadinstead ofof thethe PLSPLS “ideal”“ideal” Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 9 out of 22 Equity Ethical/Islamic () Jurist Preferences ( Juristic-Islamic /) Permissibility Frontier Secular/Banker preferences Different Financial Efficiency technologies ( ModelModel toto explainexplain paradoxesparadoxes Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 10 out of 22 Equity () TheThe needneed forfor anan IslamicIslamic EconomicsEconomics andand FinanceFinance Evolved Financial technology Efficiency ( Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 11 out of 22 Equity CommonCommon () Islamic Economics ideal ChoicesChoices Modern Islamic Finance (closest permissible point) Where do we go from here? Social development-oriented Efficiency “community” Islamic Finance ( Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 12 out of 22 Equity () How far to innovate? 0: perfectly safe 1: extreme innovation Efficiency ( Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 13 out of 22 Model:Model: basicbasic componentscomponents Credibility(x)=1-B(x|α,λ); α=π n; λ=(1- π)n-1; e.g. π=0.6 1 10 jurists Credibility 0.5 Profits 0 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1 50 jurists 0.5 0 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1 200 jurists 0.5 0 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 Profit(x)=x Credibility(x) Degree of innovation Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 14 out of 22 CompetitionCompetition Given one bank’s level of innovation, second bank can: 1.1. ShareShare monopoly profits, 2.2. InnovateInnovate further, or 3.3. ChallengeChallenge: discredit first bank to take his business (1− Fx ( )) 2 Innovator’s profits: π (x ,xx )=+−−1 ( xxFx )(1 ( )) 112 2−− 1 2 1 2()()Fx12 Fx (1− Fx ( )) 2 π (,xx )= x 2 Conservative’s profits: 212 2 −− 2()()F xFx12 SolveSolve forfor CournotCournot--NashNash equilibriumequilibrium (fixed(fixed point)point) Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 15 out of 22 TheThe EconomicsEconomics ofof JurisprudenceJurisprudence 0.7 0.26 Innovator's innovation 0.25 0.65 C o n s e rva t ive 's in n o va t io n Monoopolist's innovation 0.24 0.6 0.23 Profits 0.55 0.22 Degree of innovation 0.5 0.21 Innovator's profits Conservative'sprofits 1/2 Monopolist's profits 0.45 0.2 0 50 100 0 50 100 Number of jurists Number of jurists Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 16 out of 22 ExplainingExplaining thethe paradoxesparadoxes AsAs moremore juristsjurists getget involved:involved: At first, the industry sees more conservatism Then, beyond some point, more innovation DespiteDespite thethe rhetoric,rhetoric, banksbanks benefitbenefit fromfrom juristjurist--supportedsupported marketmarket segmentationsegmentation IfIf juristsjurists caredcared onlyonly aboutabout perceivedperceived :: quitquit atat minimumminimum “innovation”“innovation” ((proximityproximity toto conventionalconventional financefinance)) Pasadena: June 16, 2001 © Mahmoud A. El-Gamal 17 out of 22 OutstandingOutstanding questionsquestions CanCan wewe recognizerecognize asas “probable”“probable” whatwhat isis nownow treatedtreated asas aa “certainty”“certainty” (virtual(virtual consensus)?consensus)? CanCan wewe overcomeovercome outdatedoutdated suspicionssuspicions