Principles of Islamic Finance
For-profit domainNon-profit domainA balanced approach
The Two Pillars of IF
Like a bird, an economy needs the two sectors to fly
Non-profit ObligationsZakatNafaqatSharing in times of necessity,
starvation, or hardship
Obligatory donationApplies to idle money (not used for
one year)Measure against hoarding Hoarding and the current financial
crisis?
Zakat
Obligatory spending for designated relatives
Parents, family, close relativesSubject to need
Nafaqat
Safety netDistribution of wealth
Why Markets Need Non-profit Actions?
Happiness cannot be achieved by one domain
Balance allows both to flourish and thrive
Why Do We Need Both?
For-proft Domain
Prohibition of israfProhibition of usury or ribaProhibition of gharar or wagering
General Principles
Over-spending or over-utilization of resources
In consumption:extravagant spendingConspicuous consumption and status
gamesIn investment:
Greed—”irrational exuberance”Bubbles => crashes
Israf
Wealth preservation is an essential objective of Shari’ah
Israf violates preservation of wealthResults: pollution, global warming,
depletion of resourcesEssence of economics is to avoid
israf
Wealth Preservation
Riba
Riba or usury: any stipulated addition over a loan
Includes both simple and compound interest
Definition
Prohibited by all divine religions as well as Buddhism
Two-thirds of world population subscribe to this belief
Riba
Debt grows faster than wealthDebt cannot be paid except with new
debtDebt burden destroys the economy
What's Wrong with Riba?
1 pence borrowed at 4%
in 1 AD
In 1750 debt equals weight of the globe of
goldIn 1990 it equals 8190 globes!
1975 1980 1985 1990 1995 2000 2005 20070
5,000
10,000
15,000
20,000
25,000
30,000
35,000
M2 GDP Domestic debt
Debt in the US, $billions
Average growth annual rate:Debt: 39%,GDP: 21%,M2: 19%
Debt-GDP ratio: 1.3 to 2.2Debt-M2 ratio: 2.2 to 4.2
Figures
Inverted Debt Pyramid
Debt
Wealth
Inverted pyramid is not sustainableCrashes needed to “clean up” the
systemThen debts start to accumulate
again faster than wealthRecurrent crashesVery costly to maintain the system
Financial Instability
Theory: Intertemporal Budget Constraint:The present value of debt go to zeroPrevents Ponzi financing
Reality: E.U. requirements:Deficit < 3% of GDPDebt < 60% of GDP
Problem: Need to govern debt from the ground-up
Restrictions on Debt
Debt creation is integrated with wealth creation
For-profit debt must be contractually embedded in real transactions
Islamic modes of finance:Deferred sale; salam; leasing;
Islamic Finance
Sale of a good for a deferred pricePrice includes markupTime value is paired with real valueMurabaha: Financing deferred sale
Deferred Sale
Opposite of deferred salePrice is spot; good is deferredTime-value is reflected in lower price
Salam
Normal Debt Pyramid
Wealth
Debt
Gharar
Gharar is risk with delusion or deception
Risk: likelihood of loss or failure Two types of gharar:
Degree of riskForm of contract
Definition
Ex ante measureGharar if Prob (loss) ≥ Prob (gain)Example: Lottery
Where is delusion?Luck vs. skill
Low likelihood of success means low skill
The need for “feasibility studies”
Degree of Risk
Ex post measureGharar if it is a zero-sum gameExamples:
Gambling Sale of a lost carSale of a closed box
Why play a zero-sum game?
Structure of Contract
Game Structure
(− , +)(+ , −)
(A , B)
A zero-sum game cannot be played if the two parties know in advance who will win
Steps:Select first outcomeIf one player refuses to play, it is a zero-
sum outcomeRepeat with other outcomesIf all outcomes are zero-sum, the whole
game becomes a zero-sum game
How to Know it is Zero-sum?
Types of Transactions
Zero-sum
Positive-sum
Mixed
One party gains only if the other does
Interests are always aligned
Positive-sum Deals
Partnership (musharakah)
(− , −)(+ , +)
(A , B)
Contains zero-sum and positive-sum outcomes
If the zero-sum outcome is dominant, it is excessive gharar
If not, it is minor ghararGame acceptable if the positive-sum
outcome is dominant
Mixed Games
Crop-sharing (muzara'ah)
(+ , −)(+ , +)
(Land lord , Farmer)
Zero-sum games are always high risk
High risk deals invite zero-sum games
High-risk: speculationZero-sum: gambling
Relation of Types of Gharar
Riba: separates time from real transactions
Gharar: separates risk from real transactions
Time and risk are two sides of the same coin
Riba implies gharar and vise versaBoth allow obligations to grow
independent or real wealth => inverted pyramid
Relation of Riba and Gharar
Conclusion
Universal principlesEconomic groundBalanced approach
Nature of Islamic Finance
Thank You!