1	Islamic jurisprudence and finance: Trends of the past, and promises of the future Mahmoud Amin El-Gamal Rice University
2	Jurists, bankers & economists: The permanent and the changing
3	Historical “Islamic economics” Influenced jurist perceptions of the ﻋﻠﺔ(instigating factor) and ﺣﻜﻤﺔ (wisdom/ objective) of certain prohibitions e.g. myths regarding the prohibition of Ribā “fixed rate of return” – what about leasing and credit sales? “return without risk” – what about credit risks and others? “exploitation of the poor” – is still possible. In fact, it appears that the prohibitions of Ribā and Gharar are built-in prudential financial regulations Prohibition of Ribā enforces collateralizaion + “marking to market”; see http://www.ruf.rice.edu/~elgamal/files/riba.pdf Prohibition of Gharar enforces optimal “risk-sharing”; see http://www.ruf.rice.edu/~elgamal/files/gharar.pdf Convinced jurists that there is a viable radically different “Islamic” alternative, but failed to deliver for Islamic banks
4	What is the forbidden Riba? Ribā al-Jāhiliyyah Ribā al-Nasī’ah Ribā al-Nasā’ (deferment without increase) Ribā al-Fadl (increase without deferment) Muslim narrated on the authority of Abū Sa^cīd Al-Khudriy that the Prophet (pbuh) said: “Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates, and salt for salt; like for like, hand-to-hand, in equal amounts, and any increase is Riba”.
5	Riba is neither “interest” nor “usury” Not all interest is forbidden Ribā: permitted cost-plus (Murābaha), leasing (Ijāra), etc. may contain “interest”. Not all Ribā is interest: Ribā al-Nasā’ and Ribā al-Fadl The percentage does not matter (even 0% can be Ribā!)
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8	The probhibition of Riba is not merely exploitation prevention Yūsuf ^cAlī translation: [2:279] … but if ye turn back, ye shall have your capital sums; Deal not unjustly, and ye shall not be dealt with unjustly. This translation gives the wrong impression about the meaning of the verse “...lā tazlimūna wa lā tuzlamūn”, as explained by Ibn ^cAbbās, Abū Ja^cfar, and others. A correct translation as per the explanation in Tabarī and elsewhere: … but if you turn back, then you should collect your principal, with no addition or subtraction.
9	Debunking the “kindness” explanation T-D Al-Subkī in the continuation of Al-Nawawī’s Al-Majmū^c reports an opinion of ibn Kayyisān that the reason for the prohibition of Ribā is based on kindness. Proves it faulty by considering increase in trading non-Ribawī goods. Consequences of the faulty explanation: wrongly extends prohibition to permitted trades wrongly permits non-exploitative forms of Ribā
10	The prohibition of Riba is not about “return without risk” How about credit risk, and “rate of return” risk Faulty application of the Hadīth/ juristic rule “al-kharāju bi-d-Damān” Context: “kharāju l-^cabdi bi-Damānih”: returns belong to the one bearing the risk. If understood as: “returns-earned must be commensurate with risk-taken”, the statement is either a tautology, or does not apply to Murābaha with very brief risk-exposure time period.
11	The prohibition does not negate “time value of money” Logically, the return in Murābaha, Ijāra, etc. is permitted “interest” (check your Webster’s) “Māl ” does grow (eligible for Ribā and Zakāh) Al-Sarakhsī, Al-Kāsānī, Al-Zayla^cī, ibn ^cAbidīn: “The price may be increased with deferment.” Al-Shātibī, ibn Rushd, Al-Dardīr, Al-Nawawī, Al-Sāwī, Al-Shirbīnī, ibn Taymiya: “Time has a share in the price.” Al-Shāfi^cī, Al-Ghazālī: “What is worth 5 in cash is worth 6 deferred”.
12	The loan (qard) contract A debt may originate from a sale (bay^c), a lease (‘ijāra), a forward (salam), etc. or from a loan (qard) Loans are charitable contracts: forfeit ownership of the usufruct of the asset to help another If used as a finance mechanism (as commutative financial contracts), they violate the prohibition of ribā al-Nasā’, even if they are interest free! The “rate of return” on a qard hasan is Unknown
13	Can borrowing which seems to be mutually beneficial be harmful? Most people Prefer $100 today to $101 tomorrow; and prefer $101 in 51 days to $100 in 50 days ? Prefer $9 today to $12 in a year; and prefer $4000 in a year to $3000 today? Discount future losses more than they discount future gains? Discount delays more than they discount speedups? They suffer from Dynamic inconsistency
14	Dynamic inconsistency If you knew that a juicy steak was bad for you while a salad was good for you: Would you go to a steakhouse that serves great salads, or go to a salad restaurant to avoid the temptation? How else can you ensure that you will not eat a steak? The solution is through “precommitment”
15	Dynamic inconsistency There are many individuals who: Borrow today with the intention to save and payoff debts next year, … but When next year comes, borrow even more! The solution is precommitment: In Islamic finance, debts are tied to the value of the financed asset, Creditors are forced to avoid debt cycles (in contrast to conventional credit card issuers).
16	Precommitment to “mark to market” ibn Rushd’s Bidāyah + the Hadīth of Bilāl: “Marking to market” ensures that trading ratio = 1/ratio of prices = ratio of marginal utilities This ensures (Pareto) efficiency, a dominant economic notion of fairness in exchange:
17	"“It is thus apparent..." “It is thus apparent from the law that what is intended by the prohibition of Ribā is what it contains of excessive injustice (ghubn fāhish). In this regard, justice in [exchange] transactions is achieved by approaching equality. Since the attainment of such equality in items of different kinds is difficult, their values are determined instead in monetary terms (with the Dirham and the Dīnār). For things that are not measured by weight and volume, justice can be determined by means of proportionality. I mean, the ratio between the value of one item to its kind should be equal to the ratio of the value of the other item to its kind. For example, if a person sells a horse in exchange for clothes, justice is attained by making the ratio of the price of the horse to other horses the same as the ratio of the price of the clothes [for which it is traded] to other clothes. Thus, if the value of the horse is fifty, the value of the clothes should be fifty. [If each piece of clothing's value is five], then the horse should be exchanged for 10 pieces of clothing. As for [fungible] goods measured by volume or weight, they are relatively homogenous, and thus have similar benefits [utilities]. Since it is not necessary for a person owning one type of those goods to exchange it for the exact same type, justice in this case is achieved by equating volume or weight since the benefits [utilities] are very similar...”
18	Precommitment to “mark to market” and control indebtedness For Ribā Al-Nasī’ah, “Islamic” alternatives: Force the “interest rate” in a financing contract to be equal to the market determined opportunity cost of similar “opportunities” (same risk profile, market-based residual value, etc.) Encourage equity-based financing, which ensures another form of precommitment
19	The forbidden bay`u al-Gharar Jurisprudence and Prophetic Traditions : Ambiguity in contract language: e.g. two sales in one Unnecessary uncertainty: e.g. sale of the diver’s catch Undeliverable merchandise: e.g. sale of birds in the sky Al-Bājī: “sale that is dominated by gharar (ﻋﻠﻴﻪ ﻏﻠﺐ)” Professor Mustafa Al-Zarqā’: “Gharar is the sale of probable items whose existence or characteristics are not certain, due to the risky nature which makes the trade similar to gambling” Professor Al-Darīr: Gharar only invalidates (i) commutative financial contracts, (ii) in which it is substantial, (iii) integral to the contract, and (iv) for which there is no viable substitute.
20	Bay^cu l-Gharar = trading in risk Etymology: risk = re-secare (potential for loss) = risque [a ship’s] chance of being cut by a rock, definition of Qadī ^cIyād. Economics and Jurisprudence: Risk (gharar) vs. uncertainty (jahāla); Al-Qarāfī (Al-Furūq): “The definitions of gharar and jahāla are each more general in some respects and less general in others. This is the reason for the scholars’ differences over the respective natures of gharar and jahāla”. Jurisprudence: Trading in risk is the essence of insurance and other “sale-based” hedging mechanisms Fatwa ‘Ibn ^cAbidīn forbidding marine insurance Options for risk allocation: selling vs. sharing risk Pricing is problematic due to loss aversion and other complications
21	Standardized Named Contracts Asset-based financing (no Ribā): Murābaha = cost-plus sale Bay^c bi-thaman ‘ājil = credit sale ‘Ijāra (wa -qtinā’) = Lease (to purchase) Risk-sharing mechanisms (no Gharar): Mudāraba = silent partnership (commenda) Mushāraka = simple partnership Exceptions (Istihsān, ^cUrf or Maslaha!): Salam = forward with pre-paid price ‘Istisnā^c = Commission to manufacture Named contracts are mostly pre-Islamic Through futyā and qadā’, new contracts were legitimized ex post by jurists Legal fine-print to avoid Ribā and Gharar was documented in jurisprudence
22	“Convention” (ﺍﻟﻌﺭﻑ) in named contracts Appeals to “convention” (ﺍﻟﻌﺭﻑ) reference count: Al-Mabsūt (Al-Sarakhsī, Hanafī) 130 references Badā’i^c Al-Sanā’i^c (Al-Kāsānī, Hanafī) 95 references Radd Al-Muhtār (ibn-^cĀbidīn, Hanafī) 237 references Sharh Mukhtasar Khalīl (Al-Kharshī, Mālikī) 1182 references Al-Majmū^c (Al-Nawawī + Al-Subkī, Shāfi^cī) 60 references Al-Mughnī (ibn-Qudāma, Hanbalī) 102 references Appeals Relate to all contracts, including: Deposit contracts: even if unrestricted, are restricted by ﻋﺭﻑ Acceptable forms for partnership capital: determined by ﻋﺭﻑ Acceptable conditions in contracts (esp. leases and credit sales): Typical phrases: “ ﺍﻹﺟﺎﺭﺓ ﻓﻲ ﻣﻌﺘﺒﺭ ﺍﻟﻌﺭﻑ ” and “ ﺍﻟﻤﺭﺍﺑﺤﺔ ﻓﻲ ﻣﻌﺘﺒﺭ ﺍﻟﺘﺠﺎﺭ ﻋﺭﻑ ” (e.g. many of the lease restrictions imposed by today’s Sharī^ca boards are based on ibn-^cĀbidīn’s acceptance of leasing conventions in Damascus, two centuries ago).
23	Problems with “Form above function?” in juristic analogy (ﻓﻘﻬﻲ ﻗﻴﺎﺲ) Consider contracts A and B, one forbidden and the other permissible based on juristic analogy ( ﻓﻘﻬﻲ ﻗﻴﺎﺱ ) If contracts A and B are shown to be economically identical (in the Arrow-Debreu sense; A≡B), do we: Forbid B, through the apparent analogy ( ﺷﺒﻪ ﻗﻴﺎﺱ)? Permit B, while forbidding A è allows for the fallacy of composition; avoids iterative analogy = ﻗﻴﺎﺱ ﻋﻠﻰ ﻗﻴﺎﺱ? Or, revoke the earlier false juristic analogy based on the economic analysis of its proof (ﺩﻟﻴﻞ) and reasoning (ﻋﻠﺔ)? The fallacy of composition and “Islamic Financial engineering”: If A≡B+C, and the jurists forbid A, see if they accept B and C (e.g. sukūk al-salam, Murābaha lil’āmir bishshriā’) If B is forbidden, but A is permissible, and A≡B+C, try to get jurists to accept C (e.g. synthetic embedded options) Search the historical books of jurisprudence for A, B or C In all cases, charge the customer a premium for the relatively inefficient “Islamic” (or “Islamized”) alternative: è Islamic finance as Sharī^cā arbitrage è Primary beneficiaries: lawyers
24	Sharī^cā arbitrage: Marketing Islamic finance to customers as “fundamentally different”, and to regulators as “essentially the same”: OCC #867, 1999 : “… lending takes many forms … Murabaha financing proposals are functionally equivalent to, or a logical outgrowth of secured real estate lending and inventory and equipment financing, activities that are part of the business of banking.” OCC #806, 1997: “Today, banks structure leases so that they are equivalent to lending secured by private property… a lease that has the economic attributes of a loan is within the business of banking. ...Here it is clear that [ ]’s net lease is functionally equivalent to a financing transaction in which the Branch occupies the position of a secured lender…”
25	The need for “logical analogy” (ﻋﻘﻠﻲ ﻗﻴﺎﺲ) and basic research The established rulings in classical jurisprudence are of limited usefulness: What was deemed permissible two centuries ago may result in forbidden Ribā in today’s financial environment What was deemed forbidden two centuries ago may be permissible within today’s legal and regulatory framework Sharī^cā arbitrage is only profitable in the very-short-run (by definition), and self-defeating in the long-run (increased integration