principles of islamic finance

Principles of Islamic Finance

For-profit domainNon-profit domainA balanced approach

The Two Pillars of IF

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

Non-profit ObligationsZakatNafaqatSharing in times of necessity,

starvation, or hardship

Obligatory donationApplies to idle money (not used for

one year)Measure against hoarding Hoarding and the current financial

crisis?

Zakat

Obligatory spending for designated relatives

Parents, family, close relativesSubject to need

Nafaqat

Safety netDistribution of wealth

Why Markets Need Non-profit Actions?

Happiness cannot be achieved by one domain

Balance allows both to flourish and thrive

Why Do We Need Both?

For-proft Domain

Prohibition of israfProhibition of usury or ribaProhibition of gharar or wagering

General Principles

Over-spending or over-utilization of resources

In consumption:extravagant spendingConspicuous consumption and status

gamesIn investment:

Greed—”irrational exuberance”Bubbles => crashes

Israf

Wealth preservation is an essential objective of Shari’ah

Israf violates preservation of wealthResults: pollution, global warming,

depletion of resourcesEssence of economics is to avoid

israf

Wealth Preservation

Riba

Riba or usury: any stipulated addition over a loan

Includes both simple and compound interest

Definition

Prohibited by all divine religions as well as Buddhism

Two-thirds of world population subscribe to this belief

Riba

Debt grows faster than wealthDebt cannot be paid except with new

debtDebt burden destroys the economy

What's Wrong with Riba?

1 pence borrowed at 4%

in 1 AD

In 1750 debt equals weight of the globe of

goldIn 1990 it equals 8190 globes!

1975 1980 1985 1990 1995 2000 2005 20070

5,000

10,000

15,000

20,000

25,000

30,000

35,000

M2 GDP Domestic debt

Debt in the US, $billions

Average growth annual rate:Debt: 39%,GDP: 21%,M2: 19%

Debt-GDP ratio: 1.3 to 2.2Debt-M2 ratio: 2.2 to 4.2

Figures

Inverted Debt Pyramid

Debt

Wealth

Inverted pyramid is not sustainableCrashes needed to “clean up” the

systemThen debts start to accumulate

again faster than wealthRecurrent crashesVery costly to maintain the system

Financial Instability

Theory: Intertemporal Budget Constraint:The present value of debt go to zeroPrevents Ponzi financing

Reality: E.U. requirements:Deficit < 3% of GDPDebt < 60% of GDP

Problem: Need to govern debt from the ground-up

Restrictions on Debt

Debt creation is integrated with wealth creation

For-profit debt must be contractually embedded in real transactions

Islamic modes of finance:Deferred sale; salam; leasing;

Islamic Finance

Sale of a good for a deferred pricePrice includes markupTime value is paired with real valueMurabaha: Financing deferred sale

Deferred Sale

Opposite of deferred salePrice is spot; good is deferredTime-value is reflected in lower price

Salam

Normal Debt Pyramid

Wealth

Debt

Gharar

Gharar is risk with delusion or deception

Risk: likelihood of loss or failure Two types of gharar:

Degree of riskForm of contract

Definition

Ex ante measureGharar if Prob (loss) ≥ Prob (gain)Example: Lottery

Where is delusion?Luck vs. skill

Low likelihood of success means low skill

The need for “feasibility studies”

Degree of Risk

Ex post measureGharar if it is a zero-sum gameExamples:

Gambling Sale of a lost carSale of a closed box

Why play a zero-sum game?

Structure of Contract

Game Structure

(− , +)(+ , −)

(A , B)

A zero-sum game cannot be played if the two parties know in advance who will win

Steps:Select first outcomeIf one player refuses to play, it is a zero-

sum outcomeRepeat with other outcomesIf all outcomes are zero-sum, the whole

game becomes a zero-sum game

How to Know it is Zero-sum?

Types of Transactions

Zero-sum

Positive-sum

Mixed

One party gains only if the other does

Interests are always aligned

Positive-sum Deals

Partnership (musharakah)

(− , −)(+ , +)

(A , B)

Contains zero-sum and positive-sum outcomes

If the zero-sum outcome is dominant, it is excessive gharar

If not, it is minor ghararGame acceptable if the positive-sum

outcome is dominant

Mixed Games

Crop-sharing (muzara'ah)

(+ , −)(+ , +)

(Land lord , Farmer)

Zero-sum games are always high risk

High risk deals invite zero-sum games

High-risk: speculationZero-sum: gambling

Relation of Types of Gharar

Riba: separates time from real transactions

Gharar: separates risk from real transactions

Time and risk are two sides of the same coin

Riba implies gharar and vise versaBoth allow obligations to grow

independent or real wealth => inverted pyramid

Relation of Riba and Gharar

Conclusion

Universal principlesEconomic groundBalanced approach

Nature of Islamic Finance

Thank You!