Transcript its role in investment

ISLAMIC BANKING AND
ISLAMIC CAPITAL MARKET
AS IT SHOULD BE
PRESENTED AT BANK NEGARA, MALAYSIA
Nov. 24, 2009
By Prof. Dr. Iraj Toutounchian
Visiting Professor
1-Justification of the Workings of Islamic Banking
as it should be:
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WHY TO JUSTIFY?
There have been attempts to show that there are many similarities
between Islamic banking and conventional banking, both despite the
fundamental differences in philosophical foundations and non-existance
of money market due to abolition of interest (Riba) in the Islamic
Framework.
In capitalistic economy , the capital market is unduly overshadowed by the
money market which, far from providing solutions to severe economic
problems, impedes economic growth. In this system money has been
placed in an “ivory tower” which has to be given its proper place.
My Study Shows that there are no similarities between the two systems at
all. In the conventional system of zero-sum game, money is treated as
private good. In my model money has been demonstrated to have the
properties of impure public good; following Gordon Tullock’s assertion:
Money, in and of itself, is an almost perfect expression of a large
externality. Money then is judged by him to be a “public good”.
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1-Justification of the Workings of Islamic Banking
as it should be:
WHY TO JUSTIFY?
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Zero rate of interest does not imply that Qarad-ul-Hassan is
the solution for all economic activities.
There are Shariah-Compliant contracts that seem to be
sufficient instruments to finance needs of both individuals and
firms. To be able to properly launch these contracts requires
different skills to advise finance seekers as opposed to the
conventional system where valuable collateral makes it easy to
grant loan.
To substitute Islamic Contracts for interest-based loans in the
conventional system will change the character and nature of
the banks form monetary institutions to financial institutions.
They, in turn, change the legal character of money to that of
capital and hence making it eligible to claim profit.
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1-Justification of the Workings of Islamic Banking
as it should be:
Rate of interest, money and more:
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As soon as money (i.e. potential capital) is legally combined with
other factors of production it changes to actual capital:
M♀L → Actual Capital via the institution of firm,
(example: Mudarabah Contract)
Money and/or debt market will disappear due to abolition of interest.
There are as many rates of interest as there are durable goods. We
can have wheat rate of interest, copper rate of interest, gold rate of
interest, even steel plant rate of interest. (Keynes)
Keynes was the first economist to have discovered the root cause of
the Great Depression by incorporating liquidity preference in his
novel book, the General Theory
r → speculation → bubbles
It can also be shown that speculation →r > 0, based on Keynes’
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assertion.
1-Justification of the Workings of Islamic Banking
as it should be:
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Rate of interest, money and more:
Zero nominal rates of interest are necessary condition for
efficient resources allocation. (Friedman).
Later: Chocherlakota, et al:
Zero nominal rates are not only necessary but sufficient for
efficient resource allocation.
Capital, in capitalistic system is artificially kept scare due to
nominal rate of interest being positive (Keynes)
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1-Justification of the Workings of Islamic Banking
as it should be:
THE ADVERSE EFFECT OF HOARDING
Wicksell: S+ΔM+DH=I
H ≡ Hoarding ≡ Liquidity preference ≡ speculation;
DH=Dishoarding=-H; H>0 If; ΔM=0 →S> I→ unemployment
Historical evidence: more than 1/3 of savings in USA goes to the
money whirlpool and less than 2/3 goes to investment.
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1-Justification of the Workings of Islamic Banking
as it should be:
UNIDENTIFIED SUPPLY OF MONEY
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The investigation results obtained from the two appointed
independent committees in US and UK show: due to problems
faced as the result of speculative activities in the money
market [money whirlpool], the supply of money cannot be
defined. Further, if money is indefinable or includes a broad
category of “assets” then monetary policy is impossible.
According to R. S. Sayers, one of the committee members:
“The difficulty of identification has derived from the two-fold
nature of money [in capitalism]… as a medium of exchange
and as a store of value [being synonymous with hoarding and
speculation]”.
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1-Justification of the Workings of Islamic Banking
as it should be:
COOPERATION, JUSTICE, AND OPTIMALITY
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Joan Robinson: the classical economists did not treat
society as a cooperative.
Where the invisible hand fails to direct each person,
mindful only of her own gain, to promote the benefit
of all, cooperation provides a visible hand.
(Gauthier)
The object of rational cooperative choice must be an
optimal outcome….In non-cooperative interaction
the core rationality property is equilibrium, whereas
in cooperative interaction the core rationality
property is optimality. (Gauthier)
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1-Justification of the Workings of Islamic Banking
as it should be:
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John Rawls: The circumstances of justice may be
described as the normal condition under which human
cooperation is both possible and necessary.
To most western economists, the concept of efficiency is
based on Paretian value judgments which assume that:
there is no “society” above and beyond the individuals.
Thus one should be interested only in the welfare of
individuals and nothing else.
This is an evidence for the fallacy of composition.
Pareto optimality says nothing about justice.
Nath: Pareto optimality is not necessarily superior to any
non-optimum.
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1-Justification of the Workings of Islamic Banking
as it should be:
Pillars of Islamic economics:
Ultimate Goal
Justice
INCREASING- SUM
GAME
Interaction between and among pillars give rise to increasing-sum game
in an Islamic Economic System; the catalyst being social capital.
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1-Justification of the Workings of Islamic Banking
as it should be:
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Muslims feel bound to adhere to Islamic rules and
injunctions because such rules, if carefully observed,,
are for their own well-being and benefits, whether they
are able to understand and analyze them or not.
INTEGRATED MARKETS
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We, here, attempt to avoid Neoclassical-Keynesian
system to be dichotomized into independent real and
monetary subsets. It is not, says Davidson, correct to
separate monetary economics as has often been done;
hence, integrating money in Capital theory as
envisaged throughout the discussions made in my
recent book.
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THE OPERATION OF ISLAMIC BANKING
Schematic workings of two banking systems.
Islamic
Bank
Convt’l
Bank
FINANCE HOUSE
LOAN HOUSE
Depositors
1. Advocate of
Investors
Depositors
As Share
Holders
Partners
2. Partner of
Investors
Financial Institution
Depositors
1. Borrower
Lenders
2. Lender
Clients
Borrowers
Monetary Institution
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2. The Operation of Islamic banking:
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ITS ROLE IN INVESTMENT
To develop a model following simplifying assumptions are required.
All investment projects are financed by banks and in accordance with
Musharakah PLS contracts.
Acting as agents (advocates) of the depositors, the banks use their
customers’ deposits in any contracts signed but do not utilize their own
funds.
Banks collect commission from depositors on any contract signed on the
agreed terms and conditions.
As soon as PLS is signed all deposits are instantaneously legally
transformed into capital.
There is a common fund pool (CFP) in the system and all depositors share
in the prospects of all investment projects.
The depositors’ share of profits is generally proportional to the size and
the time length of their respective deposits.
Depositors’ principal money is not guaranteed by the banks.
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2. The Operation of Islamic banking:
ITS ROLE IN INVESTMENT
Assuming that (K) is the total capital needed to launch a
project in PLS, (KF) is the firm’s share of capital, and (KB) is
the bank’s share.
K= KB+ KF
Further, (∏) is the total profits,
is the bank’s share.
is the firm’s share, and
Under the condition of certainty, the expected profit E(∏) is
the same as realized profits (∏). The bank’s relative share of
profit
to that of its investors (firms),
, is :
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2. The Operation of Islamic banking:
ITS ROLE IN INVESTMENT
Altering the shares, (α), is found to be the most powerful financial policy
tool for encouraging or discouraging potential investors (firms) to
undertake new investments, or go with out it. Changing “α” does not
imply market intervention. It is simply a ratio, not the price.
Three distinct cases can be distinguished:
Case I
In this case the overall economic policy of the Islamic state
is such as to discourage potential investors.
∏B/ KB >∏F/ KF
Case II
In which there is no preference by the government to go
ahead or to go without the project; and
∏B/ KB =∏F/ KF
Case III
Where the goal is to attract potential investors by offering
them a profit share greater than their share in capital.
∏B/ KB <∏F/ KF
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2. The Operation of Islamic banking: its role in investment.
a- CERTAINTY CONDITION
Assuming output maximization and normal profit for entrepreneurs, the
demand for investible funds (DI) can be written as:
It can further be assumed that the higher the depositors share of profit the
greater would be the volume of deposits such that the supply of investible
funds (SI) is:
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2. The Operation of Islamic banking: its role in investment.
b- RISK CONDITION:
Using Private-Public Partnership(PPP) scheme.
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Having demonstrated that money, in the absence of both interest
(Riba) and speculation taking place in the money market, is an
impure public good, the Islamic banks become state-owned banks
and will be brought under public control. This is an approximation
to the proposition made by Keynes.
Governments have to be looked upon as benevolent, big risk takers
in risky conditions, and not as profit-maximizers.
Under the PPP scheme the state-owned bank’s share of profit must
be reduced in order to compensate for the falling rate of expected
profit to the investor, relative to its own share of capital.
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2. The Operation of Islamic banking: its role in investment.
b- RISK CONDITION
The hypothesized equation with its positive derivatives with respect to risk,
is the most important treatment of risk problem because it would certainly
make prospects for private investment expenditure much brighter. In so
doing, the government will actually assume the duties expected of it
because it cannot behave as a profit-maximizing agent.
Under the PPP scheme the aggregate demand for investible funds (DI) in the
presence of risk can be written as:
Demand and supply for investable funds in an Islamic Economy (risk condition) 18
2. The Operation of Islamic banking: its role in investment.
b- RISK CONDITION.
Investors are assumed to be risk averters; that is for them to
accept a higher risk, their expected rate of return must increase
in the way stated below :
Equilibrium attained in an Islamic Economy (risk condition)
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2. The Operation of Islamic banking: its role in investment.
b-RISK CONDITION.
Suppose for some reason the level of risk increases from σ1 to σ2
The risk conditions that have been initially and later caused by the
government’s overall actions will induce the government to supply more
funds for investment.
This would shift the supply curve in the lower panel from (S1) and (S`1).
To compensate for the higher risk, the banks’ share of profit relative to that
of investors has to be reduced.
To Propose a higher rate of profit to potential investors would certainly
induce them to increase their demand for investible funds.
By using PPP Scheme Islamic Banking offers a solution to this problem,
something which that capitalist system has not been able to do, either
theoretically or in practice.
To liberate capital, capital needs to assume its proper role, as is the policy
in an Islamic economy.
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3- ISLAMIC BANKING IS PRACTICALLY PART OF THE
ISLAMIC CAPITAL MARKET.
FURTHER REFINEMENT
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To follow the diversified policy of Islamic banking for
financing Investment projects, the Islamic Bank offers
another option to risk-averse Muslim households.
Take, for example, a situation in which a risk-averse
depositor is faced with two stocks with different means
and different standard deviations (risks) in their returns.
The covariance (Cov.) of the two stocks, x and y, is
Where
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3- ISLAMIC BANKING IS PRACTICALLY PART OF THE ISLAMIC
CAPITAL MARKET.
FURTHER REFINEMENT
If Px represents the proportion of income spent on stock “x”, then we should have:
(Portfolio)P = Px + Py
We know that the variance of the portfolio (P) is:
If we assume, for simplicity that the real returns of these two stocks are perfectly
correlated,
Then:
Finally:
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3- ISLAMIC BANKING IS PRACTICALLY PART OF THE
ISLAMIC CAPITAL MARKET.
FURTHER REFINEMENT
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This means that if a risk averse depositor decides to buy stock x whose
risk (σ) is 15, he will put his savings in an Islamic Bank which uses the
deposits in the two firms (x and y), where the standard deviation is less
than the purchase of one stock.
In general, because Islamic banks diversify their risk through financing
hundreds of investment projects, this reduces the weighted average risk
for individual households investing their savings in one specific
project or stock. Therefore, Islamic banking becomes more attractive
to Muslim households than primary markets.
The risk-averse household can thus choose to put its savings into a
CDA (common deposit account), rather than transacting on the Islamic
stock market. In this way, Islamic banking promotes the “real” capital
market without having to engage in the money market.
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More Complex Issues
4- SPECULATION IS THE MAJOR CAUSE OF INFLATION.
Inflation theories have failed to provide answer to the
underlying factors causing inflation. They all, one way or
another, refer to excess demand (ED) but when looked for the
answer as to: where and how ED emerges, the literature is
silent.
Based upon our findings, we have come to the conclusion that
speculation (the first derivative of interest) is the root cause of
inflation. That is, the income received by all speculators on all
durable commodities which are predominantly rich will change
the pattern of the distribution of income and wealth.
The income-wealth dominance of the rich is never without
economic consequences. Without doubt, the distribution of
income (and wealth) has a real impact on general price levels.
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More Complex Issues
4- SPECULATION IS THE MAJOR CAUSE OF INFLATION.
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To illustrate this point, imagine a society with three income
groups: high, middle, and low, whose demand for a specific
commodity is D(1),D(2), and D(3), respectively. It can easily
be shown that the total price elasticity of these three income
groups, e, is not simple the sum of the three elasticities; that
is:
More Complex Issues
4- SPECULATION IS THE MAJOR CAUSE OF INFLATION.
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We conclude that
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This is interesting result because it means that the higher
the share of the market in the hands of the rich, the lower
would be the total price elasticity of demand and the higher
would be the chance for upward pressure on the general
price level.
The message here is that in order to have a sound
economy the more equitable the distribution of income and
wealth should be.
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More Complex Issues
4- SPECULATION IS THE MAJOR CAUSED OF INFLATION.
Example:
Recent statistical evidences show that American have more
than triple the debt they had in 1982, and less than half the
savings. Further, Gini coefficient of wealth is more than 82.
Result:
If another country with the same population and the same
endowments could be found but with better equitable
distribution of income and wealth the inflation rate in the
latter country would undoubtedly be lower.
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5- Summary and Conclusions:
1.
2.
3.
With abolition of Riba (interest) and speculation as its first derivative:
Islamic banks become financial institutions,
No money and/or debt market is needed,
Outstanding feature of Islamic banking system is such that:
ΔQ
based on the availability of factors of production
ΔM
Which in turn implies money is an endogenous variable, as opposed to:
Due to
ΔM
Δr
ΔQ
in capitalism with the exception that investment is inversely related to
the rate of interest.
It also best characterizes the capitalistic system making money supply
an exogenous variable.
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5- Summary and Conclusions:
4. The connotation and implication here for endogenity of money
is basically different from those advocated by Post-Keynesian
economists. This concept which was first perceived by
econometricians divided them between horizontalists and
structuralists (or structuralists versus accomodationists) where
LM curve becomes flat. Their point of departure is whether
rate of interest comes first or credit.
5. Opportunity cost of Capital becomes zero due to:
i.e. all investment projects are, one way or another,
interdependent. Either investment is undertaken or not; (to be
or not to be). In short, they compete with each other, meaning
that cut-off rate is positive.
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5- Summary and Conclusions:
In the simplest case where there are N investment projects there will be
(N-1) cut-off rates but zero cost of capital. However in case of
opportunity cost, in capitalism, there are N cut-off rates; rate of interest
being one of them. Rate of interest plays two roles, one as the sole
opportunity cost of capital for all projects and cut-off rate.
Assuming there are only three prospective projects open to a potential
investor. He uses project (1) up to the scale (OT), but any further
capital investment in this project can compete with project (2) of size
larger than (OT) since any further expansion of output would reduce the
rate of profit on this project. The third project would more profitable
than project (2) of any scale larger than (OY).
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5- Summary and Conclusions:
Cut-off rate cannot be used as opportunity cost. In case of capitalism due
to:
rate of interest is both cost of capital and used as cut-off rate. Furthermore,
investment (I) defined to be change in stock of capital, (ΔK), in and of itself,
is an evidence that: I ≠ g(r) despite the common view to the contrary. 31
5- Summary and Conclusions:
6.
7.
8.
Primary market is endorsed but the stock prices have to be assetbased in the secondary market,
Money becomes an endogenous variable implying that as far as
there are factors of production available money supply can be
increased. In other words, money supply is demand-determined
as opposed to the conventional system in which money supply is
an exogenous variable. We share the same terminology, i.e.
“endogeneity” of money which is widely used in capitalism but
very different in both meaning and implication in an Islamic
framework. As long as markets (money and real) are segmented
and kept independent from each other we cannot have
endogenous money supply.
Required reserve ratio (RRR) can safely be reduced down to
zero due to endogenity of money. Fractional reserve applies to
interest-based banking system where supply of money is an
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exogenous variable.
5- Summary and Conclusions:
9.
Corollaries to above conclusions are;
a) In the absence of interest (Riba) money has to be
integrated in capital theory.
b) The model presented here puts an end to the
scarcity of capital, which maintains full
employment via S=I.
c) Islamic Banking becomes an integral part of
Islamic Capital Market.
d) Treating central bank as natural monopolist the
seigniorage can be brought down to zero which
produces the general price level less than
otherwise.
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5- Summary and Conclusions:
e)
f)
The Islamic central bank need not act as an independent
institution (as it is in the conventional system). In order to make
money an endogenous variable through its integration in the real
sector, it makes sense that the institution responsible for financial
policy is also part of the institution responsible for fiscal policy.
All in all, if Islamic banking, as an integral part of Islamic
economics, is properly launched in its true sense, the results,
cet. par., would be:
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Stable general price level
Full employment
Equitable distribution of income and wealth
Steady economic growth
Counter-cyclical movements.
Endogeneity of money in an Islamic setting will give rise to
automatic built-in stabilizer with the end result of a happy life for
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mankind.
Thank you
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