Principles of Islamic Finance

The Two Pillars of IF For-profit domain Non-profit domain A balanced approach

Like a bird, an economy needs the two sectors to fly

Non-profit Obligations Zakat Nafaqat Sharing in times of necessity, starvation, or hardship

Zakat Obligatory donation Applies to idle money (not used for one year) Measure against hoarding Hoarding and the current financial crisis?

Nafaqat Obligatory spending for designated relatives Parents, family, close relatives Subject to need

Why Markets Need Non-profit Actions? Safety net Distribution of wealth

Why Do We Need Both? Happiness cannot be achieved by one domain Balance allows both to flourish and thrive

For-proft Domain

General Principles Prohibition of israf Prohibition of usury or riba Prohibition of gharar or wagering

Israf Over-spending or over-utilization of resources In consumption: extravagant spending Conspicuous consumption and status games In investment: Greed—”irrational exuberance” Bubbles => crashes

Wealth Preservation Wealth preservation is an essential objective of Shari’ah Israf violates preservation of wealth Results: pollution, global warming, depletion of resources Essence of economics is to avoid israf

Riba

Definition Riba or usury: any stipulated addition over a loan Includes both simple and compound interest

Riba Prohibited by all divine religions as well as Buddhism Two-thirds of world population subscribe to this belief

What's Wrong with Riba? Debt grows faster than wealth Debt cannot be paid except with new debt Debt burden destroys the economy

In 1750 debt equals weight of the globe of gold 1 pence borrowed at 4% in 1 AD In 1750 debt equals weight of the globe of gold In 1990 it equals 8190 globes!

Debt in the US, $billions

Figures Average growth annual rate: Debt-GDP ratio: 1.3 to 2.2 M2: 19% Debt-GDP ratio: 1.3 to 2.2 Debt-M2 ratio: 2.2 to 4.2

Inverted Debt Pyramid Debt Wealth

Financial Instability Inverted pyramid is not sustainable Crashes needed to “clean up” the system Then debts start to accumulate again faster than wealth Recurrent crashes Very costly to maintain the system

Restrictions on Debt Theory: Intertemporal Budget Constraint: The present value of debt go to zero Prevents Ponzi financing Reality: E.U. requirements: Deficit < 3% of GDP Debt < 60% of GDP Problem: Need to govern debt from the ground-up

Islamic Finance 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;

Deferred Sale Sale of a good for a deferred price Price includes markup Time value is paired with real value Murabaha: Financing deferred sale

Salam Opposite of deferred sale Price is spot; good is deferred Time-value is reflected in lower price

Normal Debt Pyramid Debt Wealth

Gharar

Definition Gharar is risk with delusion or deception Risk: likelihood of loss or failure Two types of gharar: Degree of risk Form of contract

Degree of Risk Ex ante measure Gharar 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”

Structure of Contract Ex post measure Gharar if it is a zero-sum game Examples: Gambling Sale of a lost car Sale of a closed box Why play a zero-sum game?

Game Structure (A , B) (+ , −) (− , +)

How to Know it is Zero-sum? A zero-sum game cannot be played if the two parties know in advance who will win Steps: Select first outcome If one player refuses to play, it is a zero-sum outcome Repeat with other outcomes If all outcomes are zero-sum, the whole game becomes a zero-sum game

Types of Transactions Zero-sum Positive-sum Mixed

Positive-sum Deals One party gains only if the other does Interests are always aligned

Partnership (musharakah) (A , B) (+ , +) (− , −)

Mixed Games Contains zero-sum and positive-sum outcomes If the zero-sum outcome is dominant, it is excessive gharar If not, it is minor gharar Game acceptable if the positive-sum outcome is dominant

Crop-sharing (muzara'ah) (Land lord , Farmer) (+ , +) (+ , −)

Relation of Types of Gharar Zero-sum games are always high risk High risk deals invite zero-sum games High-risk: speculation Zero-sum: gambling

Relation of Riba and 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 versa Both allow obligations to grow independent or real wealth => inverted pyramid

Conclusion

Nature of Islamic Finance Universal principles Economic ground Balanced approach

Thank You!