Hopes for the Future of Islamic Finance
Dr. Abbas Mirakhor
Eminent Islamic Scholar and Executive Director
International Monetary Fund (IMF)
I am grateful to Allah SWT, to brother Muazzam Ali and to organizers of this Conference: the Institute of Islamic Banking and Insurance and the Islamic Development Bank for the opportunity of being here tonight. I am especially pleased to see our dear brother Muazzam Ali, the Dean of Islamic banking and finance. I have the pleasure of knowing him since the late 1970s. He indeed counts among the very early pioneers in this field and has greatly contributed to the growth and development of Islamic banking. We owe him an enormous debt of gratitude.
The topic of my talk is challenges to and for Islamic finance: a look into the past, present, and our hopes for the future. For someone like me, it is astonishing to realize how far and fast Islamic finance has come and how well it has managed to meet the challenges it faced in just two decades. It is astonishing because when I started my own research in this field in mid-1970s, there was virtually no analytic works on Islamic banking and finance that could explain in modern economic and financial analytic language what Islam expects of a financial system in a modern economy. And, of course, virtually no major Islamic banks existed at the time.
Based on what was known then, and in the absence of an analytic framework recognizable by modern economic and financial theory, most western observers and commentators began to refer to Islamic banking and financial system as a “zero-interest” system, by which they meant “no return to capital”. I recall when the Islamic Revolution of Iran succeeded and its leaders and economists declared they wished to eliminate Riba from their economic system, western media, including the BBC and the Wall Street Journal, commented on the impossibility of such a system referring to the thinking behind it as ” voodoo economics”.
By 1983-84, when Iran, Pakistan, and Sudan declared that they would adopt a system-wide Islamic banking and finance, the challenge was to show that such a system was first theoretically and analytically a viable financial system; second, it had to be shown that such a system was empirically workable as a whole and financially viable for each of its parts, meaning Islamic banks and financial institutions.
The challenge came from western analysts who suggested the folly of adopting such a system. Here, I summarize their arguments in six propositions:
that zero interest meant infinite demand for loanable funds and zero supply;
such a system would be incapable of equilibrating demand for and supply of loanable funds;
with zero interest rate there would be no savings;
this meant no investment and no growth;
in this system, there could be no monetary policy since no instruments of liquidity management could exist without a fixed predetermined rate of interest; and, finally,
this all meant that in countries adopting such a system there would be one way capital flight.
By 1988, this challenge was met when research, using modern analytic financial and economic theory, showed that:
A modern financial system can be designed without the need for an ex ante determined positive nominal fixed interest rate. [In fact, it had been shown by western researchers that there was no satisfactory theory that could explain the existence of a positive nominal ex ante interest rate];
Moreover, it was shown that not assuming a nominal fixed ex ante positive interest rate, i.e., no debt contract, did not necessarily mean that there would have to be zero return to capital;
The basic proposition of Islamic finance was that the return to capital would be determined ex post, and that the magnitude of return to capital was determined on the basis of the return to the economic activity in which the funds were employed;
It was that expected return which determined investment;
It was also the expected rate of return, and income, which determined savings. Therefore, there is no justification for assuming that in such a system there would be no savings and investment;
It was shown that in such a system there would be positive growth;
That monetary policy in such a system would function as in the conventional system, its efficiency depending on the availability of instruments which could be designed to manage liquidity;
Finally, it was shown that, in an open-economy macroeconomic model without an ex ante fixed interest, but with returns to investment determined ex post, there was no justification to assume that there would be a one-way capital flight.
Therefore, the system which prohibited a fixed ex ante interest rate and allowed the rate of return to capital to be determined ex post, based on the returns to the economic activity in which the funds were employed, was theoretically viable.
In the process of demonstrating the analytic viability of such a system, research also clearly differentiated it from the conventional system. In the conventional system, based on debt contracts, risks and rewards were shared asymmetrically with the debtor carrying the greatest part of the risk, and with governments enforcing the contract. Such a system had a built-in incentive structure that promoted moral hazard and asymmetric information requiring close monitoring whose costs could be managed if monitoring could be delegated to an institution which could act on behalf of the collectivity of depositor/investor; hence the reason for existence of banking institutions.
In the late 1970s – early 1980s, it was shown, mostly by Minsky, that such a system was inherently prone to instability because there would always be maturity mismatch between liabilities (short-term deposits) and assets (investment-long-term). Because the nominal values of liabilities were guaranteed, but not the nominal value of assets, when the maturity mismatch became a problem, the banks would go into a liability management mode by offering higher interest rates to attract more deposits. There was always the possibility that this process could not be sustained resulting in erosion in confidence and bank runs. Such a system, therefore, needed a lender of last resort and bankruptcy procedures, restructuring processes, and debt workout procedures to mitigate contagion.
During 1950s – 60s, Lloyd Metzler of the University of Chicago had proposed an alternative system in which contracts were based on equity rather than debt, and in which there was no guarantee of nominal values of liability since these were tied to the nominal values of assets. Metzler showed that such a system did not have the instability characteristics of the conventional banking system. In 1985, in his now classic article in the IMF staff papers, Mohsin Khan, showed the affinity of Metzler’s model to Islamic finance. Using Metzler’s basic model, Mohsin Khan demonstrated that this system produces a saddle point and is, therefore, more stable than the conventional system.
By early 1990s, it was clear that an Islamic financial system was not only theoretically viable, but had desirable characteristics that rendered it superior to a debt-based conventional system. The phenomenon growth of Islamic finance during the decade of 1990s, demonstrated the empirical and practical viability of the system.
Hopes for the future
The crises we have been witnessing in the international financial system since 1997 have set the stage for Islamic finance to demonstrate its viability as potentially a genuine alternative global financial system. The present international system is deficient in many ways of which the two most important are:
A debt-based system needs an effective lender of last resort, and the present international financial system does not have one and it is not likely that one will emerge anytime soon; and
A debt-based system needs bankruptcy proceedings, debt restructuring, and workout mechanisms and processes which the present international financial system lacks. There are preliminary discussions underway for an international sovereign debt restructuring mechanism to be established, but there are many complications. While such a mechanism, if and when it comes into being, will help reduce the risk of moral hazard and lead to better distribution of risk, it will not address the inherent fundamental fragility of a system largely based on debt contracts.
In the mean time, there are no guarantees that the international financial system has witnessed its last crises with their huge domestic costs that, at times, have threatened the very foundation and fabric of societies. The example of Indonesia is a heartbreaker; it took this country 25 years to reduce poverty by 50 percent, but it took a year of severe financial crisis to wipe out most of this gain. Countries with an otherwise viable economic system have paid dearly for crises generated by a debt structure whose nominal values and maturities were out of line, with the ability of the economic structure to service them.
There are many analyses of financial crises and a long list of their causes, but surprisingly little is said about the one underlying common denominator to all of them: debt contracts that are by nature out of sync, and unrelated to, the income flows that the underlying productive and capital assets of these countries can generate to serve them. The jury is still out as to the reasons why Malaysia did not suffer from contagion as much as other crises countries. While capital controls may have played a role, some analysts believe its liability structure and its general reliance on non-debt-creating flows made Malaysia less vulnerable to crisis.
While the financial innovations of the 1990s in the conventional system have led to mobilization of financial resources in astronomical proportions, they have also led to the equally impressive growth of debt contracts and instruments. According to the latest reports, there are now US$32 trillion of sovereign and corporate bonds alone. Compare this (plus all other forms of debt, including consumer debt in industrial countries) to the production and capital base of the global economy and one observes an inverted pyramid of huge debt piled up on a narrow production base that is supposed to generate the income flows that are to serve this debt. In short, this growth in debt has nearly severed the relationship between finance and production. Analysts are now worried about a “debt bubble”. For each dollar worth of production there are thousands of dollars of debt claims. An Islamic financial system has the potential to redress this serious threat to global financial stability because of its fundamental operating principle of a close link between financial and productive flows and because of its requirement of risk sharing.
It is now a serious advice of the IMF to developing countries that they should:
Avoid debt-creating flows;
Rely mostly on FDI;
If they have to borrow, they should ensure that their debt obligations are not bunched toward the short end of maturities;
If they have to borrow, they should ensure that their economy is producing enough primary surplus to meet their debt obligations;
Ensure that their sovereign bonds incorporate clauses (majority action clause, engagement clause, initiation clause) that make debt workout and restructuring easier. That is, to make sure that there exists better risk sharing mechanisms to avoid moral hazard; and finally,
They should put in place an efficient debt management structure.
In these circumstances, Islamic finance can provide a viable financial system on a global scale, but there are challenges that have to be met to make it so. Islamic finance has to adopt the best standards of accountability, transparency and efficiency. Fortunately, an architecture of Islamic finance on a global scale is emerging with the establishment of supporting institutions such as:
The Accounting and Auditing Organization for Islamic Financial Institutions through the efforts of Professor Rifaat Abdel Karim
The International Islamic Rating Agency
The Islamic Financial Services Board
The International Islamic Financial Market, and
The Liquidity Management Center
As this architecture emerges, Islamic finance has to develop its own genuinely Islamic financial instruments. So far, we have been free riding on financial theories and instruments developed within the context of the conventional debt and interest-based system. Unless Islamic finance develops its own genuinely Islamic financial instruments, it cannot achieve the dynamism of a system that provides security, liquidity, and diversity needed for a globally accepted financial system which would be a genuine alternative to the present debt-interest-based international financial system.
Unfortunately, there are, at the present, nothing in the Muslim world close to resembling large endowment institutions, such as the National Science Foundation, the Ford Foundation, the Rockefeller Foundation, and the like to support research in Islamic banking, finance and economics. There is, therefore, an urgent need for scholarly foundations, institutions, colleges, and universities that can train Islamic financial engineers who are well trained in economic and financial theory and methods, on the one hand, and Islamic Shariah, on the other. My generation was fortunate to have people like Dr. Anas Azzarqa and Dr. Kazem Sadr who are equally at ease with Islamic “Fiqh” as with economic theory and method. Trained by their fathers (Sheikh Mustafa Azzarqa and Ayatullah Reza Sadr, ???? ???? ??????) in “Fiqh” and having earned doctorate degrees in economics from reputable universities in the U.S.A., they were able to help the rest of us in understanding the intricacies of Islamic “Fiqh” as it related to finance. There is now a need to systematize the process of training financial engineers, experts in modern finance who are well versed in the Shariah, to expand the horizon and the menu of available Islamic financial instruments.
Islamic finance possesses the basic instruments that can be spanned into a wide, varied, and variegated menu of financial instruments. There is a theory developed in the 1980s referred to as the spanning theory which asserts that if there is one basic financial instrument it can be spanned into an infinite number of instruments. Islamic finance has at least 14 basic instruments and financial experts can span these into a much larger menu to provide greater security, liquidity, and diversity to meet the demand of investors on a global scale. Let me say once again that there is an urgent need for rich endowments to be established solely for the purpose of financially supporting institutions that can train the kind of research scholars and experts mentioned.
Let me conclude by mentioning a very important function of Islamic finance that is seldom noted: that is the ability of Islamic finance to provide the vehicle for financial and economic empowerment. Before I do so, let me recommend the works of the Peruvian economist Hernando de Soto. De Soto’s long-time research has been summarized in a recent book titled: “The Mystery of Capital”. His basic thesis is that much of the poor in developing countries are in possession of what he calls dead capital. He estimates that the developing and former communist countries possess US$9.3 trillion worth of dead capital. These are physical resources and capital that are not used for any purpose other than to provide physical service to their owners. He suggests that the ability of documenting and using this capital as a productive asset is what distinguishes the rich from the poor. How can Islamic finance help to empower financially those who are in possession of dead capital? Let me give some rudimentary examples:
Agricultural Development Bank of Iran through Mazarah partnerships with farmers helps them to convert their physical possession into assets that can generate additional capital. Also through the Islamic law of Arz Amwat Aiya of dead capital is converted into productive asset. A second example is that of the Housing Bank of Iran which through Musharakah and lease purchase agreements helps people without homes to own one. These homes can then be used to generate additional capital for the owners to undertake other productive activities. Similarly, Islamic finance can be used in other Muslim and developing countries to convert dead capital into income generating assets to financially and economically empower the poor.