An edited version of this article was first published in Euromoney's Islamic Finance Information Service, 11 December 2007.
Tarek El Diwany, December 2007
The goldsmith bankers of seventeenth century England engaged in the seemingly innocuous practice of holding precious metal coins on behalf of their depositors. In return for each deposit of coins, a goldsmith would issue the depositor with a paper receipt that promised redemption on demand. If a particular goldsmith was well trusted, many merchants would be happy to accept his receipts in payment for goods and services. A large proportion of the public therefore came to see goldsmiths’ paper not as receipts for money, but as money itself. Accordingly, depositors came to seek redemption of their receipts in ever decreasing numbers. Why bother going to the goldsmith to withdraw gold coins, if shopkeepers would accept the paper in payment anyway?
The goldsmiths soon realised the incredible business opportunity implicit in their customers’ behaviour. Instead of acting as mere safe-keepers of gold, they now offered their services to the public as money lenders. But when the public came to borrow money, they would be loaned paper receipts not gold. From the perspective of these early bankers, such a policy had one great advantage. Unlike gold, paper money could be created in the back office at almost no cost.
Naturally, many businessmen wanted to join in this new game of banking. What easier way could one find of earning a living than creating money with a printing press, and then lending it at interest? "The Bank hath benefit of interest on all moneys which it creates out of nothing", said William Paterson upon founding the Bank of England.
In those early days of banking, some commentators argued that if a banker issued a receipt promising the payment of a certain amount of gold, then he should keep that amount of gold in his vault to honour the promise when so required. The bankers argued differently. They said that because the majority of depositors did not come to the bank to claim their gold in any one period, it would be safe to issue receipts in excess of their gold stock. With this argument, the bankers attempted to justify their creation of multiple legal claims of ownership for each unit of gold in their possession.
The reserve of gold to paper in issue came to be known as the "reserve ratio", and today many major banking organisations operate a reserve ratio of less than one twentieth. Hence "fractional reserve banking". For example, HSBC’s 2006 Annual Report shows that its customers held in aggregate some £168 billion of sight deposits, yet at the same time the bank held only £3.5 billion of cash to honour requests for withdrawal of those deposits. If all of HSBC’s customers asked for their money in cash on the same day, the bank would be in a rather similar position to that of Northern Rock. The same is true for all commercial banks because the holding of a fractional reserve is the essence of their business model. They survive only so long as depositors are sufficiently confident not to ask for their money back.
Realising that heavy withdrawals might bankrupt them, early bankers made arrangements to borrow reserves of coins from one another when necessary. However, these arrangements didn’t work well in times of crisis when every bank was in need of extra reserves. It would be so much more convenient if the money of the realm could be redefined as a piece of paper, rather than a piece of gold or silver. It could then be printed in whatever quantities were necessary to satisfy calls for reserves by the commercial banking system. The government duly obliged. In 1833, Bank of England notes were made legal tender for all sums above £5.
Today’s banking practices are of course more sophisticated, though the principles remain the same. Modern commercial banks create money by crediting the borrower with an electronic entry which shows up as a balance on an account statement. But as with the goldsmiths’ paper promises of old, if all of a bank’s customers try to convert these balances into cash, the bank will soon find itself in need of extra reserves.
There is another more important similarity between these modern and early forms of banking. Whether it is a goldsmith issuing a newly printed paper receipt to a borrower, or a high street bank crediting a customer’s current account with a ledger entry, money supply increases every time a banker makes a loan. Money has become the balance sheet counterpart of debt at the macro-economic level. Therefore, widespread attempts at reducing debt also cause reductions in the supply of money and lead directly to recession. In short, society cannot repay its debt and have a job.
Given that commercial banks have the power to create new money at zero cost, it is an obvious business strategy for them to maximise the amount of money created within the existing regulatory regime. The greater the amount of money created, the greater their interest revenue and the greater their profit. The overall trend is therefore for a growth in money supply (and hence debt) over time. As a result of this tendency, every modern nation suffers from inflation. In more recent times, this inflation has been disguised by various statistical techniques. For example, although houses are the most expensive item that most individuals ever buy, they are excluded from the common measures of UK inflation.
Monetary reformers argue that the legal privilege to create money should be removed from private entities such as commercial banks and placed instead in government hands. Others go further, citing the tendency of governments to issue money for their own political advantage, and propose a commodity money system based on precious metals. Put simply, this is a system in which money is created by those who dig for it.
The American founding fathers adopted exactly this approach. Their objective was to ensure that America would not fall prey to the money creating usurers of England, amply evidenced by Jefferson’s statement that "banking establishments are more dangerous than standing armies". Gold and silver were duly enshrined as the only lawful forms of money under the American Constitution, but the struggle with the banking lobby had only just begun. Soon, Jefferson felt compelled to warn the American people against giving the banks control over their currency. Then during an address to the American people in 1837, Andrew Jackson accused the Bank of the United States of having created a recession by contracting the money supply, and this in order to damage him politically. Almost thirty years later, President Lincoln proposed measures to ensure that democracy could rise above the "Money Power". But in the long run these efforts were insufficient against the power of the banking lobby. It was Woodrow Wilson who finally conceded to the demands for a central bank by signing the Federal Reserve Act into law in 1913, a manoeuvre that effectively passed control of the American monetary system to private interests.
Alas, the coup de bank is now global. It is the culmination of some three centuries of concerted effort by a small clique of men whose interests have never coincided with those of humanity at large. These are men who were once imprisoned for their usury, and who now rule over us from the comfort of their central banking boardrooms. From here they can change the value of our money with a single announcement, and there are few greater powers than that.
The dominance of the banks is all the greater because they can choose which entrepreneurs to finance and which to overlook, and because their immense profitability allows them to support ideologies that accord with their own political agenda. The defeat of the Christian prohibition of usury is one historical example, a strategy that is being repeated with astonishing similarity in the Islamic banking sector today. In this regard, semantic distortion has always been a favoured device. Money lenders don’t practice usury anymore, they "sell mortgages". Islamic banks don’t lend money at interest, they charge a "profit mark-up".
In recent weeks, semantics has been relied upon heavily in order to minimise public awareness of the black art of money creation. At first, we were led to believe that the money used to rescue Northern Rock is taxpayers’ money. It is nothing of the sort. It is new money, created in a few keystrokes by the Bank of England. Realising the impossibility of explaining how more than £20 billion of "taxpayers’ money" could be collected and disbursed in just a few weeks, the authorities soon amended their language. The rescue package is now referred to as a "taxpayer-backed loan", which implies that if Northern Rock cannot repay the money created out of nothing by the Bank of England then the British taxpayer will. Ironic, isn't it, that the people who may be required to pay the cost of saving the British banking system are the very ones who have been hopelessly indebted by it.
If this is what happens when just one bank is caught out on its promise to pay cash to its depositors, then the consequences of a wider bank run could clearly be catastrophic. The political pressures on media organisations to avoid an open discussion of fractional reserve banking are therefore substantial. It would be a brave editor who published the headline "The Bank Doesn't Have Your Money, Mrs. Smith" but no truer words could be written.
In the immediate present, the global economy stands on a knife edge between depression and hyperinflation. The pumping into circulation of hundreds of billions of dollars in new reserve money across the world may or may not be sufficient to rescue the banking sector from its own greed. And it may or may not be enough to prevent a global recession. But in the longer term, there looms a much weightier issue. The debts of the West have now become unrepayable except by means of an inflation that will cause its empire to weaken substantially. Such a development may force the dominant banking institutions of our time to shift their commercial and political focus into the Chinese banking space, and that would be a difficult migration. The Chinese leadership will surely know that control of the money supply brings with it control of the nation, and this is a power that they will not willingly place in foreign hands. Indeed, the founding fathers reasoned likewise.
Such is the story of paper money. That innocuous receipt has given us a world in debt, a world of huge power imbalances, of booms and busts, and now perhaps a transition of empire.
Sunday, June 1, 2008
Questions For The Scholars
Tarek El Diwany, September 2007
On the 31st of January of this year I attended a conference on Islamic banking and finance organised by Euromoney in London. In answer to a question from the floor, one of the scholarly panelists remarked that "we welcome constructive comments, but there are some people who only wish to be destructive and we ignore them". Later he asked "are Muslims not in need of home financing or car financing?" with the obvious implication that his critics think they are not.
Intentional or otherwise, this was a misrepresentation of the arguments that the inner circle of Islamic finance scholars face. And while each of us is entitled to develop his own economic theory, once the "Islamic" label is used the views of other professionals should not be dismissed too lightly. Islamic banking and finance is not a football that can be monopolised in the school playground. It is not an intellectual pet that belongs to any one group of people.
Because most of the world now sees usury as something normal, perhaps even necessary, Islam has become the last remaining line of defence among those religions and ideologies that once prohibited it. If the Muslims fail to promote a truly usury-free approach in finance, few others will do so. Unfortunately, in our rush to embrace the world of secular business and politics, vital matters of Islamic law and institutional substance have been passed over with almost casual arrogance. What makes this so dangerous is that business and politics are two of the least desirable forces for shaping the laws and institutions of a nation. It was their union that gave birth to the modern interest-based monetary system in London some three hundred years ago. William of Orange wanted power, the money lenders wanted a banking monopoly, and their creation was called the Bank of England.
Undoubtedly, powerful forces are now at work that seek to overturn the Islamic prohibition of usury. In many cases their tactics are identical to those that were deployed in Christendom. In the late Middle Ages and early Renaissance, the Scholastics argued against "retrovenditio" (known in Islam as bay al-`ina). They prohibited the exchange of a bottle of wine now for a bottle of the same wine several months later (a practice that has much in common with riba al-nasa) because wine became more valuable as it matured. Such contracts were recognised as covert forms of usury by the Church scholars, but it was the construction of a usurious loan through the combination of three permissible contracts (the "Contractum Trinius") that finally defeated them. Here was the door through which money lending at interest entered the daily practice of merchants in the Christian world, just as the practice of "murabahah-to-the-purchase-orderer" has done in the Islamic world.
The famous chronicler Matthew Paris describes a contract document from the year 1235CE, in which the bishops of the day had found a way of borrowing money at usury whilst keeping the appearance of staying within the Biblical law. Of the money lenders who were lending to the bishops, Paris writes: "... they circumvented the needy in their necessities, cloaking their usuries under the show of trade, and pretending not to know that whatever is added to the principal is usury by whatever name it is called". Cloaking their usuries under the show of trade? How depressingly familiar.
A few years ago, one occasionally heard scholars mentioning Michael Rowbotham on the subject of money creation by the commercial banking system. Although he does not believe that interest should be prohibited, the prominence of Michael's work was a hopeful sign because his thesis on the monetary system is essentially correct. Like me he believes that the business model of commercial banking involves the creation of money out of nothing (fraud) and its subsequent lending at interest (riba). For Muslims to focus on narrow issues of contractual structure when the monetary framework has been corrupted in this manner, is to guarantee the failure of the Islamic finance experiment. Islamic finance cannot succeed with un-Islamic money.
A key point in this connection is that no one, neither an individual nor a financial institution, should give a promise that is impossible to keep. If a bank promises to pay £100 in cash to a customer on demand, then the bank should keep £100 in cash in order to fulfil that promise when the customer requires it. This of course is not the case in modern commercial banking. For example, HSBC’s 2006 Annual Report shows that its customers held in aggregate some £150 billion of sight deposits, yet at the same time HSBC held only £3.5 billion of cash to honour requests for withdrawal of those deposits. If all of HSBC’s customers asked for their money in cash on the same day, HSBC would be forced to close its doors.
This practice of holding a fractional reserve is a classic case of gharar. It is also the misrepresentation that lies at the core of commercial banking. By lending out money that they are supposed to be holding for sight depositors, commercial banks increase the money supply. In the process they also increase their interest revenue, which is of course the point of the whole exercise. Inflation, indebtedness and the forced economic growth that Michael Rowbotham speaks of, become features of our economic landscape as a consequence of this practice.
In the West, the longstanding policy has been to regulate rather than abandon the fractional reserve system. Since commercial banks practice gharar by holding insufficient reserves to redeem their deposit liabilities, central banks offer a "lender of last resort" function in order to make extra reserves available to them in times of need. And since banks practice riba by promising in advance to pay depositors a percentage gain on their deposits, come what may, they must adhere to capital adequacy ratios. These require that each bank holds a cushion of capital to protect depositors from poor performance of the bank’s loan book.
The briefest of consideration would inform us that the lender of last resort function and the capital adequacy ratio, like many other features of the modern banking landscape, are a consequence of not implementing Shari`ah. This is why it is so utterly depressing to find Muslim executives and academics proclaiming the need for these very practices within an Islamic banking system. At the London conference, proud announcements were made of progress towards an "Islamic debt market", "adoption of the Bank for International Settlements framework" and "closer ties with the International Capital Markets Association". Our leaders do not seem to see that the structures with which they are trying to integrate could only grow in the soil of usury. Attempting to invent their Islamic equivalent is just as unreasonable as attempting the creation of an Islamic thief. Can we not have the vision to grow our own tree, in the soil of Islam, and harvest the pleasant fruit that would undoubtedly grow on it?
The impact of the interest-based money creation framework on the property market is well known in many countries. In the United Kingdom in 1963 the average house price was £3,160. Ten years later it was £9,942, ten years after that £26,471, and today it is some £200,000. Trying to save for a house under these circumstances is impossible for all but the highest earners in society. For the rest of us, by the time we have reached our savings target, the price of the house has doubled or trebled. The only practical option in these circumstances is to borrow the money in order to buy the house. But money borrowed from the bank is newly created money, and when that money is injected into the housing market, house prices rise. The act that allows one person to buy a house, causes house prices to become unaffordable for the next person. This is an awful trap, one that "Islamic" mortgages do nothing to solve because the banks that offer them are also creating money out of nothing. By promoting Islamic mortgages as a solution to our home financing needs, our problems only worsen in the long run.
In the model of home finance that I have promoted over the last decade or so, the financier buys a proportion of a property and the client buys the remainder. These two parties own the property as partners, and subsequently rent it to a tenant. The tenant in most cases is the home buying client. Over the years, the client can buy the financier’s share of the property, and if he does so he pays the market price for the share he buys. But the client doesn’t have to buy the financier’s share, and this is a vital feature because it means that the client is not in debt to the financier. At the end of the partnership term, if the client has not bought all of the financier’s share, the house will be sold on the open market and the sale proceeds will be divided between the partners according to the ratio of their partnership shares at that time. In this structure, the client can never be repossessed by the financier because he is never in debt to the financier. Neither can he find himself in "negative equity", the position that often occurs in interest-based mortgages where the debt owed on a property is greater than the value of the property. If the financier owns 80% of a property and the property falls in value to nothing, then the financier owns 80% of nothing and the client does not need to compensate him with a single penny.
Imagine if such a product existed in a Western country today. If the people of Britain or America knew that there was a way of buying a home and not being in debt, millions of them would go for it. And if they saw that it was the Muslims who were providing them with that solution, they would surely think more highly of Islam. Yet in almost every "Islamic" mortgage product available today, capital risk is shifted from the bank to the customer just as in a interest-based loan. The customer is in debt to the bank, just as in an interest-based loan. The monthly cash-flows are the same or higher than an interest-based loan. In many cases the rental rate can rise as unpredictably as the interest charge on a variable rate mortgage, because it is linked to LIBOR. And in a default, the customer may find himself in a position of negative equity, just as in an interest-based loan. Is it any surprise that non-Muslims who hear of the principles of Shari`ah, and are then confronted with its implementation, should mock us for what is happening?
So I do believe that Muslims need home finance. It’s just that my way of doing it accords with the spirit and tradition of our religion, while the ways of Islamic banking usually don’t. And I am not alone in my feelings. I speak to many financial executives who are equally disillusioned. Their feelings include guilt ("I feel like I just participated in the Manhattan Project and regret what I have helped to create"), derision ("... these instruments are pretty much a sham, and I still cannot believe that eminent scholars passed this product as Shari`ah compliant") and hostility ("... the more I practice Islamic finance, the more I hate it"). When practitioners within the industry make comments such as these, they cannot just be ignored. There is clearly a fundamental problem.
It is well known that Islamic banks cannot charge interest on a late payment of an installment due under a murabahah contract. We also know that tawarruq financing has been allowed by some scholars. Here, the client buys a commodity for delivery now against deferred payment, then sells the commodity into the market at a lower price for immediate cash payment. The bank arranges both transactions using various commodity dealers, and in this way maintains the fiction that it is trading commodities with its client. The substance of the transaction, of course, is that the client is borrowing money at interest from the bank. But to allow tawarruq and simultaneously prohibit the charging of a penalty for late payment of a debt is pointless in every sense and here is why, in the words of an Islamic banking lawyer: "We were told that banks couldn’t charge an interest penalty in event of late payment by the client. So we re-financed a late murabahah installment by entering into a tawarruq contract with the client. In that way the bank received its interest penalty, in effect".
Most of these practices rely heavily on the legal device of contract combination. A loan, a promise and a gift are each halal from the perspective of Shari`ah, yet their combination easily produces a "money-now for more-money-later" transaction. No scholar would permit such a transaction, yet the combination of two halal transactions produces precisely the same result in "murabahah-to-the-purchase-orderer". Why is the first combination seen as a form of riba, and the second not?
If the spirit of Shari`ah is being broken by means of contract combination, then so too is the letter of the law being broken by the practice of "benchmarking". In many modern lease contracts, the rental rate charged to the tenant is linked to LIBOR. Since LIBOR for any given period is not known until the commencement of that period, the tenant in a property cannot know what rent he will have to pay for its use in future periods. Rentals may therefore increase substantially and unexpectedly if market interest rates rise and, for many holders of Islamic mortgages, an increase of two or three percent can make the monthly payments unaffordable. There is an overwhelming consensus in Shari`ah that the price of an object of sale should be known at the time of contract signing, and rent is of course a price that is paid for the right to use a property. Yet this fundamental requirement is contradicted by linking rental payments to future measures of LIBOR. Clearly, many banks want to promote LIBOR linking in Islamic finance because the funds they use to finance their customers are themselves borrowed at an interest rate that is linked to LIBOR. Is it not therefore obvious that if the banks have financed themselves at interest, then the funds obtained thereby must be deployed in a way that mimics an interest-based loan? Wasn’t Islamic banking meant to challenge the interest-based model, rather than integrate into it?
And what of the forward sale of partnership shares? Let us imagine that two partners establish a business with contributions of 50 each in capital. These two partners share the profits in any way that they choose, and share losses in accordance with their share of the capital. It is therefore not permitted to agree at the outset that one partner will buy the other’s share, say at a price of 60 in one year’s time, since this would contractually guarantee a profit of 10 to the partner who sells his shares. Recent AAOIFI standards (3/1/6/2, 2003-2004) echo this point, but things are very different in practice.
For example, a forward sale of partnership shares was agreed in the USD3.5 billion sukuk issued by PCFC in UAE during 2006. The sukuk documentation requires that one musharakah partner buys the other’s share at a price that provides a pre-agreed gain of up to 10.125% per year. There are several clauses in the PCFC prospectus that achieve this, though one needs a forensic ability to identify them: "The Obligor shall execute a purchase undertaking (the Purchase Undertaking) in favour of the Issuer. Pursuant to the Purchase Undertaking, the Obligor shall undertake to purchase the Issuer’s Units at the Relevant Exercise Price"; "Relevant Exercise Price means ... a US Dollar amount equal to the aggregate of (i) the Outstanding Sukuk Amount and (ii) the Scheduled Accumulated Sukuk Return Amount"; "Scheduled Accumulated Sukuk Return Amount means an amount calculated as follows: Scheduled Accumulated Sukuk Return Amount = Outstanding Sukuk Amount x 10.125% x (n/360) where: n means the number of days for the period ..." PCFC Development FCZO, Offering Circular, January 2006
Is this not a shallow subterfuge in violation of industry standards? Certainly the terminology is typical of an interest-bearing bond, fixing in advance a positive return for investors in the sukuk. Yet look how it is portrayed by an executive at Dubai Islamic Bank: "Many readers may have been wondering as to how the PCFC Sukuk carries a pre-known profit rate whereas the Islamic Sharia is averse to the idea of fixing a return on investment at the outset. In order to substantiate that for all practical purposes, the above is a projected return based on a business plan prepared and submitted by PCFC to the investors, I would like to quote the gist of a relevant clause from the Musharaka agreement entered into between PCFC and the Special Purpose Co (SPC) representing scores of investors in the Sukuk: ‘PCFC acknowledges that it has prepared the business plan based on which the Musharaka is expected to yield a minimum profit of (say 15 per cent) per annum on its total equity. The Musharaka profit will be distributed between PCFC and the investors at the ratio of 30:70 respectively.’ " http://archive.gulfnews.com/articles/06/03/29/10028930.html
Nowhere in the above explanation does the fact of a purchase undertaking appear, something that is central to the PCFC structure. What do the profit-sharing arrangements matter, if one partner has undertaken to purchase the other’s share for a 10.125% profit on maturity?
If it becomes our culture to turn a blind eye to these various goings-on, then it will be more than just our jurisprudence that suffers. If Shari`ah violation is off-limits as a subject of discussion, why should the commercial performance of Islamic financial products come under any greater scrutiny? In all of the marketing buzz surrounding PCFC, for example, few people have asked why a government guaranteed organisation in the UAE should be raising funds at a pre-agreed financing cost that is several hundred basis points above US dollar LIBOR. If one is going to agree a financing cost on money at the outset, why not borrow at LIBOR instead and save tens of millions of dollars in the process? As another example, whilst researching for a client recently, I came across a fund that won the second place prize at an award ceremony in Saudi Arabia a couple of years ago. The fund focussed on North American equities and had lost some 16% of its value since inception, after fees. Over the same period, the market as a whole had risen by 3.3%. On average, initial investors in the fund would have done better by choosing their portfolio components at random from the Dow Jones Islamic Index.
An honest discussion of issues such as these is central to the long term credibility of the Islamic finance industry, but instead we get empty hype and a refusal to engage on the key topics. There has been a deliberate weeding out of traditionalists and plain speakers, with the result that too many of the people promoted to the conference platform are long on compromise or short on vision. All of this has been substantially encouraged by the secular banking lobby. It is they who are making a trillion dollars or more every year from the practice of usury. Why would they ever promote an industry that seeks to abolish it? And shouldn’t we be slightly concerned that so many of our leading scholars have achieved prominence through the patronage of these institutions?
Consider the consequences if we fail to defeat usury. The business model of many modern corporations is to borrow money from the bank at interest and then to invest that money into corporate operations yielding a higher rate of return on assets. Under this model, the more the firm borrows, the more profit it makes. So if the interest rate is 5% and the return on assets 20% then, for every extra dollar borrowed, another 15 cents in profit is generated. Firms therefore compete to borrow very large amounts of money from the banks, which as we know can create it out of nothing almost ad infinitum. Those that are able to borrow the most swallow up business opportunities that would otherwise have gone to smaller firms. The results of this can be seen everywhere. In the production process, owner-managers become disinterested lower-paid employees. In our landscape, characterful villages are encircled by anonymous housing estates and massive sheds. In our environment, intensive production puts stress on natural resources. And in countless communities, local influence over local affairs declines, as centres of control move to headquarters that are often thousands of miles away. These are some of the monuments to modern leverage.
In the Muslim world, leverage has traditionally been hard to achieve. If one cannot borrow at interest then how can one generate that 15 cents of profit on every dollar? If funds were raised on a profit-sharing basis, the entrepreneur would have to share the 15 cents with the investor and this would change the nature of financing activity entirely. The financier’s motive would be to choose the most profitable projects available, not necessarily the biggest ones. And since financiers could not charge interest, they would no longer be so concerned about the amount of collateral possessed by their clients. Under profit-sharing, what matters most to financiers is that their clients should have good management and profitable business opportunities. It is a system in which wealth begins to circulate among the poor once again, since profitable ideas and good management are not the sole privilege of the rich. Regrettably, in the Middle East today, debt financed mega-projects are announced on a regular basis. The marketing literature assumes that we will be proud of these projects, when in fact it is shameful that such huge resources are being centralised in the hands of so few people and organisations. Communities build societies, bankers and leverage don’t.
I know of many dedicated people who joined the Islamic finance movement in the hope that it would help to relieve the injustice of debt. But they have become mere tools by which debt can be spread more widely. Decades of marketing failed to convince the people of Saudi Arabia to borrow at interest. Tawarruq has achieved it in a couple of years. That is the legacy of modern Islamic banking and finance, and the interest-based establishment is laughing at us for having let it happen so easily. What good is our Shari`ah if it becomes a commodity for sale to usurers? Or if we exempt ourselves from its rules, in ignorance of their wisdom?
We believe that falsehood always destroys itself eventually. The Western financial system is no exception to this rule, and neither is our present "Islamic" banking system. If we had adopted a banking and finance strategy worthy of the word "Islamic", then in financial crises to come we could have demonstrated the superiority of our banking and finance model to the whole world. But we have adopted the interest-based system as our template, and so that opportunity has already been lost. Come the day, the Islamic banking system will be in just as much of a mess as its Western counterpart, its legal tricks swept away on a tide of financial distress. And I may just laugh more than I cry.
On the 31st of January of this year I attended a conference on Islamic banking and finance organised by Euromoney in London. In answer to a question from the floor, one of the scholarly panelists remarked that "we welcome constructive comments, but there are some people who only wish to be destructive and we ignore them". Later he asked "are Muslims not in need of home financing or car financing?" with the obvious implication that his critics think they are not.
Intentional or otherwise, this was a misrepresentation of the arguments that the inner circle of Islamic finance scholars face. And while each of us is entitled to develop his own economic theory, once the "Islamic" label is used the views of other professionals should not be dismissed too lightly. Islamic banking and finance is not a football that can be monopolised in the school playground. It is not an intellectual pet that belongs to any one group of people.
Because most of the world now sees usury as something normal, perhaps even necessary, Islam has become the last remaining line of defence among those religions and ideologies that once prohibited it. If the Muslims fail to promote a truly usury-free approach in finance, few others will do so. Unfortunately, in our rush to embrace the world of secular business and politics, vital matters of Islamic law and institutional substance have been passed over with almost casual arrogance. What makes this so dangerous is that business and politics are two of the least desirable forces for shaping the laws and institutions of a nation. It was their union that gave birth to the modern interest-based monetary system in London some three hundred years ago. William of Orange wanted power, the money lenders wanted a banking monopoly, and their creation was called the Bank of England.
Undoubtedly, powerful forces are now at work that seek to overturn the Islamic prohibition of usury. In many cases their tactics are identical to those that were deployed in Christendom. In the late Middle Ages and early Renaissance, the Scholastics argued against "retrovenditio" (known in Islam as bay al-`ina). They prohibited the exchange of a bottle of wine now for a bottle of the same wine several months later (a practice that has much in common with riba al-nasa) because wine became more valuable as it matured. Such contracts were recognised as covert forms of usury by the Church scholars, but it was the construction of a usurious loan through the combination of three permissible contracts (the "Contractum Trinius") that finally defeated them. Here was the door through which money lending at interest entered the daily practice of merchants in the Christian world, just as the practice of "murabahah-to-the-purchase-orderer" has done in the Islamic world.
The famous chronicler Matthew Paris describes a contract document from the year 1235CE, in which the bishops of the day had found a way of borrowing money at usury whilst keeping the appearance of staying within the Biblical law. Of the money lenders who were lending to the bishops, Paris writes: "... they circumvented the needy in their necessities, cloaking their usuries under the show of trade, and pretending not to know that whatever is added to the principal is usury by whatever name it is called". Cloaking their usuries under the show of trade? How depressingly familiar.
A few years ago, one occasionally heard scholars mentioning Michael Rowbotham on the subject of money creation by the commercial banking system. Although he does not believe that interest should be prohibited, the prominence of Michael's work was a hopeful sign because his thesis on the monetary system is essentially correct. Like me he believes that the business model of commercial banking involves the creation of money out of nothing (fraud) and its subsequent lending at interest (riba). For Muslims to focus on narrow issues of contractual structure when the monetary framework has been corrupted in this manner, is to guarantee the failure of the Islamic finance experiment. Islamic finance cannot succeed with un-Islamic money.
A key point in this connection is that no one, neither an individual nor a financial institution, should give a promise that is impossible to keep. If a bank promises to pay £100 in cash to a customer on demand, then the bank should keep £100 in cash in order to fulfil that promise when the customer requires it. This of course is not the case in modern commercial banking. For example, HSBC’s 2006 Annual Report shows that its customers held in aggregate some £150 billion of sight deposits, yet at the same time HSBC held only £3.5 billion of cash to honour requests for withdrawal of those deposits. If all of HSBC’s customers asked for their money in cash on the same day, HSBC would be forced to close its doors.
This practice of holding a fractional reserve is a classic case of gharar. It is also the misrepresentation that lies at the core of commercial banking. By lending out money that they are supposed to be holding for sight depositors, commercial banks increase the money supply. In the process they also increase their interest revenue, which is of course the point of the whole exercise. Inflation, indebtedness and the forced economic growth that Michael Rowbotham speaks of, become features of our economic landscape as a consequence of this practice.
In the West, the longstanding policy has been to regulate rather than abandon the fractional reserve system. Since commercial banks practice gharar by holding insufficient reserves to redeem their deposit liabilities, central banks offer a "lender of last resort" function in order to make extra reserves available to them in times of need. And since banks practice riba by promising in advance to pay depositors a percentage gain on their deposits, come what may, they must adhere to capital adequacy ratios. These require that each bank holds a cushion of capital to protect depositors from poor performance of the bank’s loan book.
The briefest of consideration would inform us that the lender of last resort function and the capital adequacy ratio, like many other features of the modern banking landscape, are a consequence of not implementing Shari`ah. This is why it is so utterly depressing to find Muslim executives and academics proclaiming the need for these very practices within an Islamic banking system. At the London conference, proud announcements were made of progress towards an "Islamic debt market", "adoption of the Bank for International Settlements framework" and "closer ties with the International Capital Markets Association". Our leaders do not seem to see that the structures with which they are trying to integrate could only grow in the soil of usury. Attempting to invent their Islamic equivalent is just as unreasonable as attempting the creation of an Islamic thief. Can we not have the vision to grow our own tree, in the soil of Islam, and harvest the pleasant fruit that would undoubtedly grow on it?
The impact of the interest-based money creation framework on the property market is well known in many countries. In the United Kingdom in 1963 the average house price was £3,160. Ten years later it was £9,942, ten years after that £26,471, and today it is some £200,000. Trying to save for a house under these circumstances is impossible for all but the highest earners in society. For the rest of us, by the time we have reached our savings target, the price of the house has doubled or trebled. The only practical option in these circumstances is to borrow the money in order to buy the house. But money borrowed from the bank is newly created money, and when that money is injected into the housing market, house prices rise. The act that allows one person to buy a house, causes house prices to become unaffordable for the next person. This is an awful trap, one that "Islamic" mortgages do nothing to solve because the banks that offer them are also creating money out of nothing. By promoting Islamic mortgages as a solution to our home financing needs, our problems only worsen in the long run.
In the model of home finance that I have promoted over the last decade or so, the financier buys a proportion of a property and the client buys the remainder. These two parties own the property as partners, and subsequently rent it to a tenant. The tenant in most cases is the home buying client. Over the years, the client can buy the financier’s share of the property, and if he does so he pays the market price for the share he buys. But the client doesn’t have to buy the financier’s share, and this is a vital feature because it means that the client is not in debt to the financier. At the end of the partnership term, if the client has not bought all of the financier’s share, the house will be sold on the open market and the sale proceeds will be divided between the partners according to the ratio of their partnership shares at that time. In this structure, the client can never be repossessed by the financier because he is never in debt to the financier. Neither can he find himself in "negative equity", the position that often occurs in interest-based mortgages where the debt owed on a property is greater than the value of the property. If the financier owns 80% of a property and the property falls in value to nothing, then the financier owns 80% of nothing and the client does not need to compensate him with a single penny.
Imagine if such a product existed in a Western country today. If the people of Britain or America knew that there was a way of buying a home and not being in debt, millions of them would go for it. And if they saw that it was the Muslims who were providing them with that solution, they would surely think more highly of Islam. Yet in almost every "Islamic" mortgage product available today, capital risk is shifted from the bank to the customer just as in a interest-based loan. The customer is in debt to the bank, just as in an interest-based loan. The monthly cash-flows are the same or higher than an interest-based loan. In many cases the rental rate can rise as unpredictably as the interest charge on a variable rate mortgage, because it is linked to LIBOR. And in a default, the customer may find himself in a position of negative equity, just as in an interest-based loan. Is it any surprise that non-Muslims who hear of the principles of Shari`ah, and are then confronted with its implementation, should mock us for what is happening?
So I do believe that Muslims need home finance. It’s just that my way of doing it accords with the spirit and tradition of our religion, while the ways of Islamic banking usually don’t. And I am not alone in my feelings. I speak to many financial executives who are equally disillusioned. Their feelings include guilt ("I feel like I just participated in the Manhattan Project and regret what I have helped to create"), derision ("... these instruments are pretty much a sham, and I still cannot believe that eminent scholars passed this product as Shari`ah compliant") and hostility ("... the more I practice Islamic finance, the more I hate it"). When practitioners within the industry make comments such as these, they cannot just be ignored. There is clearly a fundamental problem.
It is well known that Islamic banks cannot charge interest on a late payment of an installment due under a murabahah contract. We also know that tawarruq financing has been allowed by some scholars. Here, the client buys a commodity for delivery now against deferred payment, then sells the commodity into the market at a lower price for immediate cash payment. The bank arranges both transactions using various commodity dealers, and in this way maintains the fiction that it is trading commodities with its client. The substance of the transaction, of course, is that the client is borrowing money at interest from the bank. But to allow tawarruq and simultaneously prohibit the charging of a penalty for late payment of a debt is pointless in every sense and here is why, in the words of an Islamic banking lawyer: "We were told that banks couldn’t charge an interest penalty in event of late payment by the client. So we re-financed a late murabahah installment by entering into a tawarruq contract with the client. In that way the bank received its interest penalty, in effect".
Most of these practices rely heavily on the legal device of contract combination. A loan, a promise and a gift are each halal from the perspective of Shari`ah, yet their combination easily produces a "money-now for more-money-later" transaction. No scholar would permit such a transaction, yet the combination of two halal transactions produces precisely the same result in "murabahah-to-the-purchase-orderer". Why is the first combination seen as a form of riba, and the second not?
If the spirit of Shari`ah is being broken by means of contract combination, then so too is the letter of the law being broken by the practice of "benchmarking". In many modern lease contracts, the rental rate charged to the tenant is linked to LIBOR. Since LIBOR for any given period is not known until the commencement of that period, the tenant in a property cannot know what rent he will have to pay for its use in future periods. Rentals may therefore increase substantially and unexpectedly if market interest rates rise and, for many holders of Islamic mortgages, an increase of two or three percent can make the monthly payments unaffordable. There is an overwhelming consensus in Shari`ah that the price of an object of sale should be known at the time of contract signing, and rent is of course a price that is paid for the right to use a property. Yet this fundamental requirement is contradicted by linking rental payments to future measures of LIBOR. Clearly, many banks want to promote LIBOR linking in Islamic finance because the funds they use to finance their customers are themselves borrowed at an interest rate that is linked to LIBOR. Is it not therefore obvious that if the banks have financed themselves at interest, then the funds obtained thereby must be deployed in a way that mimics an interest-based loan? Wasn’t Islamic banking meant to challenge the interest-based model, rather than integrate into it?
And what of the forward sale of partnership shares? Let us imagine that two partners establish a business with contributions of 50 each in capital. These two partners share the profits in any way that they choose, and share losses in accordance with their share of the capital. It is therefore not permitted to agree at the outset that one partner will buy the other’s share, say at a price of 60 in one year’s time, since this would contractually guarantee a profit of 10 to the partner who sells his shares. Recent AAOIFI standards (3/1/6/2, 2003-2004) echo this point, but things are very different in practice.
For example, a forward sale of partnership shares was agreed in the USD3.5 billion sukuk issued by PCFC in UAE during 2006. The sukuk documentation requires that one musharakah partner buys the other’s share at a price that provides a pre-agreed gain of up to 10.125% per year. There are several clauses in the PCFC prospectus that achieve this, though one needs a forensic ability to identify them: "The Obligor shall execute a purchase undertaking (the Purchase Undertaking) in favour of the Issuer. Pursuant to the Purchase Undertaking, the Obligor shall undertake to purchase the Issuer’s Units at the Relevant Exercise Price"; "Relevant Exercise Price means ... a US Dollar amount equal to the aggregate of (i) the Outstanding Sukuk Amount and (ii) the Scheduled Accumulated Sukuk Return Amount"; "Scheduled Accumulated Sukuk Return Amount means an amount calculated as follows: Scheduled Accumulated Sukuk Return Amount = Outstanding Sukuk Amount x 10.125% x (n/360) where: n means the number of days for the period ..." PCFC Development FCZO, Offering Circular, January 2006
Is this not a shallow subterfuge in violation of industry standards? Certainly the terminology is typical of an interest-bearing bond, fixing in advance a positive return for investors in the sukuk. Yet look how it is portrayed by an executive at Dubai Islamic Bank: "Many readers may have been wondering as to how the PCFC Sukuk carries a pre-known profit rate whereas the Islamic Sharia is averse to the idea of fixing a return on investment at the outset. In order to substantiate that for all practical purposes, the above is a projected return based on a business plan prepared and submitted by PCFC to the investors, I would like to quote the gist of a relevant clause from the Musharaka agreement entered into between PCFC and the Special Purpose Co (SPC) representing scores of investors in the Sukuk: ‘PCFC acknowledges that it has prepared the business plan based on which the Musharaka is expected to yield a minimum profit of (say 15 per cent) per annum on its total equity. The Musharaka profit will be distributed between PCFC and the investors at the ratio of 30:70 respectively.’ " http://archive.gulfnews.com/articles/06/03/29/10028930.html
Nowhere in the above explanation does the fact of a purchase undertaking appear, something that is central to the PCFC structure. What do the profit-sharing arrangements matter, if one partner has undertaken to purchase the other’s share for a 10.125% profit on maturity?
If it becomes our culture to turn a blind eye to these various goings-on, then it will be more than just our jurisprudence that suffers. If Shari`ah violation is off-limits as a subject of discussion, why should the commercial performance of Islamic financial products come under any greater scrutiny? In all of the marketing buzz surrounding PCFC, for example, few people have asked why a government guaranteed organisation in the UAE should be raising funds at a pre-agreed financing cost that is several hundred basis points above US dollar LIBOR. If one is going to agree a financing cost on money at the outset, why not borrow at LIBOR instead and save tens of millions of dollars in the process? As another example, whilst researching for a client recently, I came across a fund that won the second place prize at an award ceremony in Saudi Arabia a couple of years ago. The fund focussed on North American equities and had lost some 16% of its value since inception, after fees. Over the same period, the market as a whole had risen by 3.3%. On average, initial investors in the fund would have done better by choosing their portfolio components at random from the Dow Jones Islamic Index.
An honest discussion of issues such as these is central to the long term credibility of the Islamic finance industry, but instead we get empty hype and a refusal to engage on the key topics. There has been a deliberate weeding out of traditionalists and plain speakers, with the result that too many of the people promoted to the conference platform are long on compromise or short on vision. All of this has been substantially encouraged by the secular banking lobby. It is they who are making a trillion dollars or more every year from the practice of usury. Why would they ever promote an industry that seeks to abolish it? And shouldn’t we be slightly concerned that so many of our leading scholars have achieved prominence through the patronage of these institutions?
Consider the consequences if we fail to defeat usury. The business model of many modern corporations is to borrow money from the bank at interest and then to invest that money into corporate operations yielding a higher rate of return on assets. Under this model, the more the firm borrows, the more profit it makes. So if the interest rate is 5% and the return on assets 20% then, for every extra dollar borrowed, another 15 cents in profit is generated. Firms therefore compete to borrow very large amounts of money from the banks, which as we know can create it out of nothing almost ad infinitum. Those that are able to borrow the most swallow up business opportunities that would otherwise have gone to smaller firms. The results of this can be seen everywhere. In the production process, owner-managers become disinterested lower-paid employees. In our landscape, characterful villages are encircled by anonymous housing estates and massive sheds. In our environment, intensive production puts stress on natural resources. And in countless communities, local influence over local affairs declines, as centres of control move to headquarters that are often thousands of miles away. These are some of the monuments to modern leverage.
In the Muslim world, leverage has traditionally been hard to achieve. If one cannot borrow at interest then how can one generate that 15 cents of profit on every dollar? If funds were raised on a profit-sharing basis, the entrepreneur would have to share the 15 cents with the investor and this would change the nature of financing activity entirely. The financier’s motive would be to choose the most profitable projects available, not necessarily the biggest ones. And since financiers could not charge interest, they would no longer be so concerned about the amount of collateral possessed by their clients. Under profit-sharing, what matters most to financiers is that their clients should have good management and profitable business opportunities. It is a system in which wealth begins to circulate among the poor once again, since profitable ideas and good management are not the sole privilege of the rich. Regrettably, in the Middle East today, debt financed mega-projects are announced on a regular basis. The marketing literature assumes that we will be proud of these projects, when in fact it is shameful that such huge resources are being centralised in the hands of so few people and organisations. Communities build societies, bankers and leverage don’t.
I know of many dedicated people who joined the Islamic finance movement in the hope that it would help to relieve the injustice of debt. But they have become mere tools by which debt can be spread more widely. Decades of marketing failed to convince the people of Saudi Arabia to borrow at interest. Tawarruq has achieved it in a couple of years. That is the legacy of modern Islamic banking and finance, and the interest-based establishment is laughing at us for having let it happen so easily. What good is our Shari`ah if it becomes a commodity for sale to usurers? Or if we exempt ourselves from its rules, in ignorance of their wisdom?
We believe that falsehood always destroys itself eventually. The Western financial system is no exception to this rule, and neither is our present "Islamic" banking system. If we had adopted a banking and finance strategy worthy of the word "Islamic", then in financial crises to come we could have demonstrated the superiority of our banking and finance model to the whole world. But we have adopted the interest-based system as our template, and so that opportunity has already been lost. Come the day, the Islamic banking system will be in just as much of a mess as its Western counterpart, its legal tricks swept away on a tide of financial distress. And I may just laugh more than I cry.
A Soil of Our Own
An edited version of this article appeared in the December 2006 edition of Business Islamica magazine.
Tarek El Diwany, February 2006
In Summer 2005, Michael Chussodovsky wrote an article on LIVE 8 and its campaign to reduce global poverty (http://www.globalresearch.ca). Here is a short extract from that article:"The concerts are totally devoid of political content. They concentrate on simple and misleading cliches. They use poverty as a marketing tool and a consumer-advertising gimmick to increase the number of viewers and listeners worldwide. Live 8 creates an aura of optimism. It conveys the impression that poverty can be vanquished with the stroke of the pen. All we need is good will. The message is that G8 leaders, together with the World Bank and the IMF, are ultimately committed to poverty alleviation. In this regard, the concerts are part of the broader process of media disinformation. They are used as a timely public relations stunt for Prime Minister Tony Blair, who is hosting the G-8 Summit at Gleneagles, Scotland. Tony Blair is presented as stepping up his campaign to convince other G8 nations 'to take action on poverty' ".
Chussodovsky has identified a methodology here. It is used by the establishment to weaken a potentially threatening movement from within and, because it is a methodology, it can be identified elsewhere. For example, with a few minor alterations, Chussodovsky's words suddenly become relevant to the Islamic banking industry:
"The Islamic banking industry concentrates on simple and misleading cliches. It uses Islam as a marketing tool and a consumer-advertising gimmick to increase its following among Muslims worldwide. Islamic bankers create an aura of optimism. They convey the impression that usury can be vanquished with the launch of more financial products. All we need is to set up more Islamic banks. The message is that Western bankers, together with their friends at the World Bank and the IMF, are ultimately committed to providing an Islamic paradigm. In this regard, Islamic banking conferences are part of the broader process of media disinformation. Leading establishment figures are often presented as stepping up their campaign to convince others 'to level the playing field for Islamic finance' ".
The platitudes and gloss of LIVE 8 are repeated in the award ceremonies at Islamic banking conferences. Interest-based loans with Islamic labels win the top prizes but few people stop to ask who exactly is glorifying this trash. Could it just be that these awards are a means of promoting the type of Islamic finance that the interest-based establishment wants? A type that doesn't threaten the existing financial paradigm? In the UK last year, the banking sector made USD 40 billion equivalent in profit. It will try to guard this profit-making machine against all possible threats, whether commercial or ideological. So what if it costs them a few hundred million to do so? To co-opt Islamic banking and influence it from within may in fact be the cheapest strategy available. A member of the design team that won a recent industry award told me privately that the product "is a sham", that he "can't believe the scholars approved it". I can believe it. The methodology is working.
One of the main factors that has propelled us to this low point is, I believe, a lack of vision and confidence among leading Muslims to develop and implement a distinctively Islamic framework for modern financial activity. It is as if critical sections of Muslim academia and business have been intellectually colonised by the West. Hence one finds little difference in the material used to teach finance courses in the Gulf as compared to universities in London or New York, and the symptoms of this malaise have spread well beyond academia. A suit and tie still seems to earn the kind of respect that a thobe and beard cannot, even in the Islamic banking industry.
During my first week of employment in Islamic finance, I suggested to a director of an Islamic housing organisation in London that we should develop together a diminishing partnership home financing product. I told him we could prove a concept together. My firm's financing know-how plus his operational knowledge would fit together nicely, I thought. We would share capital risk together. His clients need no longer fear negative equity, no longer suffer from debt stress. (This was a true diminishing partnership by the way, not at all like the interest-based loans that were to appear in the name of diminishing partnership a few years later.) After maybe fifteen minutes, the director proudly informed me that he'd recently agreed a 5 year loan at 7.5% through Barclays Bank and wasn't interested in Islamic finance. Looking back I realise the extent of my naivety, imagining that a Muslim director of an Islamic housing organisation would be interested to develop an Islamic financing paradigm. But at the time, the thought uppermost in my mind was that my firm's business plan was in real trouble. If this was the state of the Muslim community, what hope Islamic finance?
The story repeated itself as the years went by. On a visit to a Gulf-based Islamic bank in 1996, I proposed the issuance of bonds with coupons linked to project revenues and redeemable at net asset value. A client of mine needed several million dollars to finance an infrastructure project in a stable Muslim country. I saw this as a great opportunity to launch a genuinely halal financial instrument that could act as a template for years to come. This particular institution had a balance sheet in the billions of dollars, but once again I found myself speaking with men who wanted to do "money-now for more-money-later" transactions, men who seemed incapable of thinking beyond the confines of a McGraw Hill textbook. The idea of tradable revenue bonds switched them off entirely, but when an executive from a big Western bank visited this same institution to propose a commodity cash-and-carry with a limp LIBOR related return, then this was a breakthrough! Truly innovative! Soon a variety of technical sounding product names sprouted in the literature. "Revolving murabahahs" and "notes issuance facilities" became the flavour of the day. Often, there would be a feature in some trade magazine, accompanied of course by the obligatory sentence to inform us that the Islamic banking industry is an exciting niche market worth $150 billion, growing at 15% per year.
In those days, commentators were still arguing that murabahah was just a temporary phase in Islamic banking, something to get by with until a truly Islamic product could be found. People were saying "yes, I know, it's not ideal, but it's a start", "one step is better than no step", and so on. But it is quite possible that no step would have been better than that step because, in the formulation of modern murabahah, principles were established that have led us to tawarruq and a whole new selection of excuses. I am thinking in particular of the use of contract combination in the design of Islamic financial products but also, at a more general level, of the promotion of legal form over substance in so much of what the industry does. The resultant transformation has been remarkable. For decades in the Middle East, much of the Muslim public resisted tempting offers of interest-bearing loans from the banking system. The sinful connotations were sufficiently strong to block the borrowing impulse. But the emergence of tawarruq has changed all of this by providing a convenient fig-leaf for borrowing at interest. This largely explains why, for example, consumer borrowing in Saudi Arabia has leapt by more than 50% over the last year. It is therefore rather ironic to find a scholar who was for many years a leading voice in favour of those questionable legal principles now warning his ex-clients that their products are becoming indistinguishable from interest. The time to warn and prohibit passed long ago, Sheikh. Your fatawa commanded such a high price not because you were more capable than other scholars, but because you were willing to permit what others would not, and because your opinions suited what the bankers wanted to do. The result is that the money-now for more-money-later transaction has become a cornerstone of the Islamic banking business model, just as it is in interest-based commercial banking. The least we can do now is to make sure that those who opened the legal flood gates, so to speak, are not given responsibility for closing them again.
It is rather worrying that the collapse of the Christian prohibition of usury has left behind a similar story, one of jurisprudence and intellectual thought influenced by a powerful banking establishment. That influence has continued up to the present day. For example, the London Business School is a creation of the major British commercial banks and the Citibank Foundation spends much of its funds on financial education. A powerful anti-banking thesis is most unlikely to emerge under the patronage of such institutions, and the executives who grow up on that theoretical diet will know little of the interest-free economic paradigm. Yet such men are invited to develop and manage Islamic banking departments across the world.
The Western range of instruments (overdrafts, fixed income bonds, home mortgages, derivatives) are a fruit that can only grow upon a certain tree (the institutional framework of fiat money, a central bank, fractional reserve banking and so on) and that tree can only grow in a certain soil (the concepts of riba, gharar, speculation). We cannot Islamise this tree or its fruit any more than we can Islamise theft, but I am not advocating that we "go back to the Stone Age" or regress in some other way as orthodox economists occasionally suggest. We must simply plant our seed in a soil of our own, let the tree grow, and harvest whatever fruit results. Dr. Daud Bakar, who has spent many years researching the matter, finds no record of deposit-taking banks in the early centuries of Islam yet the Islamic Empire was advanced in every way given the technological limits of the time. Why then has the Western model of commercial banking been so unquestioningly adopted by the modern pioneers of Islamic banking? Did we really think that we could transplant a model that grew so uniquely in the soil of usury to the soil of Shari`ah? The scheme should have been a non-starter, but it lives, sustained by the smoke and mirrors of the Islamic banking community, producing ever more absurd semantics as the years go by.
I have believed for a long time that the Muslim world can only solve its problems if it first understands what those problems are. This seems an obvious idea to me, in Islamic banking and finance especially, but apparently not so to others. The continuing suspicions and legal confusions in Islamic banking have only reinforced the fact that something is badly wrong in the industry. It is especially sad that the industry has never seriously investigated the theory of fractional reserve banking, or recognised that it consistently predicts the development of the economic landscape around us. Without this vital re-appraisal of the raison d'etre of commercial banking, its Islamic variant will in due course be absorbed by the interest-based sector and disappear entirely. This will happen because there will be no substantive difference between the two. Already those who pull the strings at the conferences are debating whether the word "Islamic" should be dropped from the industry's marketing effort, and Harvard's 2006 conference has the integration of Islamic finance into the mainstream as its theme. Stephen Green, CEO of HSBC, goes so far as to suggest that the success of Islamic banking products "will be their acceptance in the mainstream financial community" (Islamic Banking and Finance Magazine #4, UK, 2004). No Stephen, it's precisely the opposite. The failure of Islamic banking and finance will be measured by the degree to which it is accepted in the mainstream. If such a dreadful thing should happen it will be a victory for usury and a defeat for Islam and for the suffering people of this world.
But if we are to Islamise modern day Islamic banking and finance, a number of radical policy changes are required. Where these policies cannot be implemented immediately, they should at least be put on the agenda for discussion. I do not care whether it is in the Muslim world or the non-Muslim world that such a debate takes place for they are reforms that will benefit all of mankind, as indeed Islam is meant to. Here are some of those ideas in brief:
Tarek El Diwany, February 2006
In Summer 2005, Michael Chussodovsky wrote an article on LIVE 8 and its campaign to reduce global poverty (http://www.globalresearch.ca). Here is a short extract from that article:"The concerts are totally devoid of political content. They concentrate on simple and misleading cliches. They use poverty as a marketing tool and a consumer-advertising gimmick to increase the number of viewers and listeners worldwide. Live 8 creates an aura of optimism. It conveys the impression that poverty can be vanquished with the stroke of the pen. All we need is good will. The message is that G8 leaders, together with the World Bank and the IMF, are ultimately committed to poverty alleviation. In this regard, the concerts are part of the broader process of media disinformation. They are used as a timely public relations stunt for Prime Minister Tony Blair, who is hosting the G-8 Summit at Gleneagles, Scotland. Tony Blair is presented as stepping up his campaign to convince other G8 nations 'to take action on poverty' ".
Chussodovsky has identified a methodology here. It is used by the establishment to weaken a potentially threatening movement from within and, because it is a methodology, it can be identified elsewhere. For example, with a few minor alterations, Chussodovsky's words suddenly become relevant to the Islamic banking industry:
"The Islamic banking industry concentrates on simple and misleading cliches. It uses Islam as a marketing tool and a consumer-advertising gimmick to increase its following among Muslims worldwide. Islamic bankers create an aura of optimism. They convey the impression that usury can be vanquished with the launch of more financial products. All we need is to set up more Islamic banks. The message is that Western bankers, together with their friends at the World Bank and the IMF, are ultimately committed to providing an Islamic paradigm. In this regard, Islamic banking conferences are part of the broader process of media disinformation. Leading establishment figures are often presented as stepping up their campaign to convince others 'to level the playing field for Islamic finance' ".
The platitudes and gloss of LIVE 8 are repeated in the award ceremonies at Islamic banking conferences. Interest-based loans with Islamic labels win the top prizes but few people stop to ask who exactly is glorifying this trash. Could it just be that these awards are a means of promoting the type of Islamic finance that the interest-based establishment wants? A type that doesn't threaten the existing financial paradigm? In the UK last year, the banking sector made USD 40 billion equivalent in profit. It will try to guard this profit-making machine against all possible threats, whether commercial or ideological. So what if it costs them a few hundred million to do so? To co-opt Islamic banking and influence it from within may in fact be the cheapest strategy available. A member of the design team that won a recent industry award told me privately that the product "is a sham", that he "can't believe the scholars approved it". I can believe it. The methodology is working.
One of the main factors that has propelled us to this low point is, I believe, a lack of vision and confidence among leading Muslims to develop and implement a distinctively Islamic framework for modern financial activity. It is as if critical sections of Muslim academia and business have been intellectually colonised by the West. Hence one finds little difference in the material used to teach finance courses in the Gulf as compared to universities in London or New York, and the symptoms of this malaise have spread well beyond academia. A suit and tie still seems to earn the kind of respect that a thobe and beard cannot, even in the Islamic banking industry.
During my first week of employment in Islamic finance, I suggested to a director of an Islamic housing organisation in London that we should develop together a diminishing partnership home financing product. I told him we could prove a concept together. My firm's financing know-how plus his operational knowledge would fit together nicely, I thought. We would share capital risk together. His clients need no longer fear negative equity, no longer suffer from debt stress. (This was a true diminishing partnership by the way, not at all like the interest-based loans that were to appear in the name of diminishing partnership a few years later.) After maybe fifteen minutes, the director proudly informed me that he'd recently agreed a 5 year loan at 7.5% through Barclays Bank and wasn't interested in Islamic finance. Looking back I realise the extent of my naivety, imagining that a Muslim director of an Islamic housing organisation would be interested to develop an Islamic financing paradigm. But at the time, the thought uppermost in my mind was that my firm's business plan was in real trouble. If this was the state of the Muslim community, what hope Islamic finance?
The story repeated itself as the years went by. On a visit to a Gulf-based Islamic bank in 1996, I proposed the issuance of bonds with coupons linked to project revenues and redeemable at net asset value. A client of mine needed several million dollars to finance an infrastructure project in a stable Muslim country. I saw this as a great opportunity to launch a genuinely halal financial instrument that could act as a template for years to come. This particular institution had a balance sheet in the billions of dollars, but once again I found myself speaking with men who wanted to do "money-now for more-money-later" transactions, men who seemed incapable of thinking beyond the confines of a McGraw Hill textbook. The idea of tradable revenue bonds switched them off entirely, but when an executive from a big Western bank visited this same institution to propose a commodity cash-and-carry with a limp LIBOR related return, then this was a breakthrough! Truly innovative! Soon a variety of technical sounding product names sprouted in the literature. "Revolving murabahahs" and "notes issuance facilities" became the flavour of the day. Often, there would be a feature in some trade magazine, accompanied of course by the obligatory sentence to inform us that the Islamic banking industry is an exciting niche market worth $150 billion, growing at 15% per year.
In those days, commentators were still arguing that murabahah was just a temporary phase in Islamic banking, something to get by with until a truly Islamic product could be found. People were saying "yes, I know, it's not ideal, but it's a start", "one step is better than no step", and so on. But it is quite possible that no step would have been better than that step because, in the formulation of modern murabahah, principles were established that have led us to tawarruq and a whole new selection of excuses. I am thinking in particular of the use of contract combination in the design of Islamic financial products but also, at a more general level, of the promotion of legal form over substance in so much of what the industry does. The resultant transformation has been remarkable. For decades in the Middle East, much of the Muslim public resisted tempting offers of interest-bearing loans from the banking system. The sinful connotations were sufficiently strong to block the borrowing impulse. But the emergence of tawarruq has changed all of this by providing a convenient fig-leaf for borrowing at interest. This largely explains why, for example, consumer borrowing in Saudi Arabia has leapt by more than 50% over the last year. It is therefore rather ironic to find a scholar who was for many years a leading voice in favour of those questionable legal principles now warning his ex-clients that their products are becoming indistinguishable from interest. The time to warn and prohibit passed long ago, Sheikh. Your fatawa commanded such a high price not because you were more capable than other scholars, but because you were willing to permit what others would not, and because your opinions suited what the bankers wanted to do. The result is that the money-now for more-money-later transaction has become a cornerstone of the Islamic banking business model, just as it is in interest-based commercial banking. The least we can do now is to make sure that those who opened the legal flood gates, so to speak, are not given responsibility for closing them again.
It is rather worrying that the collapse of the Christian prohibition of usury has left behind a similar story, one of jurisprudence and intellectual thought influenced by a powerful banking establishment. That influence has continued up to the present day. For example, the London Business School is a creation of the major British commercial banks and the Citibank Foundation spends much of its funds on financial education. A powerful anti-banking thesis is most unlikely to emerge under the patronage of such institutions, and the executives who grow up on that theoretical diet will know little of the interest-free economic paradigm. Yet such men are invited to develop and manage Islamic banking departments across the world.
The Western range of instruments (overdrafts, fixed income bonds, home mortgages, derivatives) are a fruit that can only grow upon a certain tree (the institutional framework of fiat money, a central bank, fractional reserve banking and so on) and that tree can only grow in a certain soil (the concepts of riba, gharar, speculation). We cannot Islamise this tree or its fruit any more than we can Islamise theft, but I am not advocating that we "go back to the Stone Age" or regress in some other way as orthodox economists occasionally suggest. We must simply plant our seed in a soil of our own, let the tree grow, and harvest whatever fruit results. Dr. Daud Bakar, who has spent many years researching the matter, finds no record of deposit-taking banks in the early centuries of Islam yet the Islamic Empire was advanced in every way given the technological limits of the time. Why then has the Western model of commercial banking been so unquestioningly adopted by the modern pioneers of Islamic banking? Did we really think that we could transplant a model that grew so uniquely in the soil of usury to the soil of Shari`ah? The scheme should have been a non-starter, but it lives, sustained by the smoke and mirrors of the Islamic banking community, producing ever more absurd semantics as the years go by.
I have believed for a long time that the Muslim world can only solve its problems if it first understands what those problems are. This seems an obvious idea to me, in Islamic banking and finance especially, but apparently not so to others. The continuing suspicions and legal confusions in Islamic banking have only reinforced the fact that something is badly wrong in the industry. It is especially sad that the industry has never seriously investigated the theory of fractional reserve banking, or recognised that it consistently predicts the development of the economic landscape around us. Without this vital re-appraisal of the raison d'etre of commercial banking, its Islamic variant will in due course be absorbed by the interest-based sector and disappear entirely. This will happen because there will be no substantive difference between the two. Already those who pull the strings at the conferences are debating whether the word "Islamic" should be dropped from the industry's marketing effort, and Harvard's 2006 conference has the integration of Islamic finance into the mainstream as its theme. Stephen Green, CEO of HSBC, goes so far as to suggest that the success of Islamic banking products "will be their acceptance in the mainstream financial community" (Islamic Banking and Finance Magazine #4, UK, 2004). No Stephen, it's precisely the opposite. The failure of Islamic banking and finance will be measured by the degree to which it is accepted in the mainstream. If such a dreadful thing should happen it will be a victory for usury and a defeat for Islam and for the suffering people of this world.
But if we are to Islamise modern day Islamic banking and finance, a number of radical policy changes are required. Where these policies cannot be implemented immediately, they should at least be put on the agenda for discussion. I do not care whether it is in the Muslim world or the non-Muslim world that such a debate takes place for they are reforms that will benefit all of mankind, as indeed Islam is meant to. Here are some of those ideas in brief:
[1] Serious moves should be made to reform the present interest-based monetary system. It should be replaced over time with a commodity based currency issued under the supervision of the state.
[2] A 100% reserve requirement should be imposed on the sight deposit accounts of deposit-taking institutions and the payment of returns on these accounts should be prohibited by law.
[3] As a transitionary step, securitisation and tradability of real assets should be encouraged so as to provide holders of money with an alternative liquid investment that does not suffer longer term devaluation due to the operation of credit creation by the commercial banks. With the elimination of fractional reserve banking, the need for such securities will diminish substantially.
[4] Investment accounts should be operated as off-balance sheet items, and should be legally segregated from the payment transmission operations of deposit takers. The investment accounts would carry a 0% reserve requirement, and returns to investors as well as withdrawal rights from the accounts would be subject to the performance and liquidity of the underlying portfolio of assets.
[5] Interest-based forms of finance should be phased out over time by statute, and incentives put in place to encourage genuine alternatives such as operating leases and installment payment facilities.
[6] Revenue bonds should be promoted to finance infrastructure projects where an identifiable revenue stream exists (a toll road project for example). These will be easier to administer than profit sharing securities since project revenues can be directly observed, whereas profits can be distorted through creative accounting.
[7] Diminishing partnership financing (of the kind in which capital risk is genuinely shared) should be promoted for capital investment and financing of large ticket items, in property and transport for example. Insolvency due to an unequal apportionment of risk between the user and provider of funds will then be a far less frequent occurrence, but a legal and financial framework should be established to minimise the negative social and economic consequences of those cases in which investments do fail. I am thinking here of good corporate governance, proper regulation of the financial sector, the establishment of mutual insurance funds, the promotion of good portfolio management practices, and so on.
[8] Interest-free loans should be provided to lower income groups for home purchase, car purchase and education through a public sector agency. This would be the lowest cost option for society to fund many such purchases, and has been operated successfully in the past. For example, until recently, interest-free loans from the government were a major source of home finance in Saudi Arabia.
[9] The use of margined transactions on financial markets should be restricted in accordance with Shari`ah such that at most only one counterparty can defer delivery of a countervalue to a future date. This policy will help to reduce speculative dealing in key areas.
[10] Contract combination in Islamic banking should be explicitly prohibited under industry standards because it allows the synthesis of interest-based loans in the name of Islam. This would include a prohibition on the use of mutual promises for achieving the same ends.
[11] A wealth tax should be instituted where it has not already been put in place in order to address issues of wealth inequality, and to address the harmful impact of monopolistic control over mineral and other resources in certain countries of the Muslim world. Zakat upon mineral extraction is a right of the Ummah.
Away from the purely financial arena, there is a more general reform that urgently needs to be implemented. Many Muslim countries desperately need a legal framework that an honest businessman can trust, a framework that operates speedily and impartially. The benefits of such a reform for economic and social progress are hard to underestimate. When one sees counterparties based in the Muslim world choosing English law and English courts to mediate their financial disputes, this really says something about the present condition of the Ummah. To think, lands under Islamic rule were once renowned as a place of justice for all. Now, in many cases, they are not even a place of justice for the Muslims.
To move forward we must have the vision to strike out in our own direction, upon our own methodology, to grow our own tree. We should know that the way to achieve a truly interest-free paradigm is to practice Islamic finance for the sake of Allah, not for the sake of profit, not even for the sake of economic development. Then, when that paradigm has been built, the profit-seeking businessmen can join the party and play by the new set of rules. The strategy we see now, however, is the precise opposite of this. The rules are being set by the profit-seeking businessmen and the paradigm builders are being ignored. The longer we travel on this road, the harder it will be to find our way back when the time comes. But let us not be disheartened by the task ahead. Many of the problems we face are the result of an un-Islamic framework. Derivative products are a cause of volatility, not the cure for it. Interest is not a recompense for inflation, it is a cause of it. Take away that which is haram, instead of re-labelling it, and many of our economic problems will simply disappear.
I'm told that Brazil, the world's most indebted country, is cutting down its rainforest at the fastest ever rate in order to meet its debt repayments. The Amazon rainforest produces a large proportion of the world's oxygen supply, and at this rate of deforestation it will almost disappear within three generations. Where have we heard that interest might be the cause of such ecological disasters? Not in many places. It is the truth that dare not speak its name, the one the media doesn't discuss very much. In its present condition Islamic banking will not restrain this monster. Its clients will still have to repay debt at interest, in all but name. They will still have to cut down the rainforest to satisfy their repayment schedules. So it has become a matter of global ecological importance that Islamic banking adopts a different paradigm, that it becomes more of a solution and less of a get-rich-quick bandwagon.
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