“Say: My Lord has commanded me to equity.”
(al-An‘aam 7:29)
Banking plays a central role in modern economic and financial life. However, modern capitalist banking, as deeply entrenched as it is in the free-market economy, has key points of conflict with Islamic law; key points that cannot be compromised on. Therefore, the duty that is laid upon Islamic scholars and Muslim economists is “to devise a system which can smoothly replace the modern system.”[1] This essay will discuss three key areas of difference: interest (ribaa), fractional-reserve banking, and fiat money and the role of private banks in the money creation process. It shall be suggested that these should be replaced in order by: mudaarabah (equity loans), full-reserve banking, and government issued money, whether this then be based on a bi-metallic (gold and silver) standard or remain fiat. Also periodic reflections will be made as to the root causes of the current 2009 financial crisis, or “The Great Recession”[2] and the part that the above mentioned three categories had to play in bringing it about. The purpose is to show that a transition away from capitalist banking and into a fully Islamic system is not only viable, but also would provide a more stable as well as socially equitable system.
Interest
The prohibition on interest is made abundantly clear in the Qur’an.
“Those who swallow down usury cannot arise except as one whom Satan has prostrated by (his) touch does rise. That is because they say, trading is only like usury; and Allah has allowed trading and forbidden usury.”
(Baqarah 2:275)
There is an abundance of verses and narrations emphasizing this, so allowing riba is not an option for an Islamic scholar. However, as the verse makes clear Allah (swt) has not prohibited trade or profit. Islam recognizes financial endeavours as an essential part of human society and life. Rather, as with all things in Islam, certain types of the activity are banned not the whole category in general.[3] These shar‘i restrictions are not much dissimilar to any other financial regulations imposed by a government on its own market. As Sayyid Sadr points out, neither of the two extremes complete central control of the market (as suggested by communists) nor a completely unregulated market (an extreme form of capitalism) are realistically functional; rather a middle-way is required.[4]
However, without the incentive of gaining interest from a loan there is not much reason for the owner of capital to lend it out. Still, Islam has provided an alternative to interest and that is mudaarabah, which is a type of profit-sharing equity loan whereby the owner of the capital lends out his wealth to the worker (‘aamil) who then carries out business with the wealth and the two then share the profit.[5] Therefore, “at the simplest level the Islamic system can be considered as an equity-based, rather than an interest-based, system.”[6] This system of course offers a higher percentage of risk for the commercial bank as it has significantly higher level of liability because it is directly involved in the financial activity of the one to whom the money is borrowed. As Neale points out “it is important to note that banks are generally unwilling to take equity stakes in companies, preferring to view their role as lenders rather than owners.”[7]
Because of the way current legislation is designed in most western countries, banks can act as lenders without much fear of loss. They can engage in profitable and risky endeavours knowing that if worse comes to worse they will be ‘bailed out’ by the central bank. “Insuring depositors against loss removes their incentive to monitor the institutions’ management, and gives managers perverse incentives to go for broke. They cash up if things go well, but the government pays if things go badly.”[8] This policy has come increasingly under question as now bankers that had been involved in risky ‘NINJa’ loans[9] and toxic-mortgage assets are being bailed out by taxpayers’ money for what was essentially a gamble.
It has come to light that one of the major causes for the financial crisis was the granting of so called ‘naked credit default swaps’[10] or CDS loans to companies such as AIG. This gambling proved so lucrative that the size of the new CDS market became 60 trillion dollars,[11] whilst the size of the world economy is said to only $69.49 trillion.[12] It is now the government who is bailing out the bankers by indebting itself to them, with the taxpayers picking up the bill. As Mohsin Khan lucidly points out:
“The Islamic System may prove to be better suited to adjusting to shocks that result in banking crises and disruption of the payments mechanism of the country. In an equity-based system that excludes predetermined interest rates and does not guarantee the nominal value of deposits, shocks to asset positions are immediately absorbed by changes in the value of shares (deposits) held by the public bank...”[13]
Essentially, if the banks were more liable for their loans they would invest more conservatively. That is why Islamic banking, relying on equities rather than a fixed rate-of-return on interest, as Khan points out, offers a more stable financial system that is more shock absorbent. Simultaneously, the mudaarabah contracts, offered as equity deposit accounts present a realistically viable form of income for the bank. As Henry Simons and Milton Friedman pointed out a bank could offer two types of accounts (with 100 % reserve requirements)[14], one with normal secure and risk-free bank account with no interest paid out and a nominal fee charged for administration costs, whilst another one as a mudaarabah account with an un-fixed rate-of-return, which is much akin to buying shares in the bank.[15]
Fiat money
Gold and silver have generally been the accepted forms of money. Even after the advent of paper money currency were generally backed by reserves in gold in the storage of the central bank. The paper money could at any moment be taken to the central bank and exchanged for its value in gold or silver. However in 1971, during the presidency of Nixon, the USA decided to cancel the Bretton Woods pact[16] and decided to ‘float’ the dollar.[17] This is why the modern currencies such as the dollar, pound and euro are known as ‘fiat money’, because the money itself has no intrinsic value, it only has value because people agree it does.
Many Islamic scholars have argued that according to the shari’ah currency should be based on the gold dinar and silver dirham, because this was the sunnah of the Prophet (s) and because he made zaka>t (alms tax) payable on them and ordered the cutting of the thief’s hand for a quarter of a dinar.[18] Thus they have in effect denied a system of fiat money.
Although it may not actually be necessary to return to minting gold and silver coins, which may seem rather bulky and cumbersome in modern life, however a return to a gold standard is deemed necessary as the current system gives too much power to the central banks. One must understand that “in the days of the gold standard, notes could be cashed in for gold and the central bank might not have had sufficient gold to pay. Nowadays there is no such obligation. The (central) Bank can always meet withdrawals by its depositors by printing new banknotes.”[19] In effect the central bank “can manufacture cash in indefinite quantities.”[20] Of course printing money whenever you want is quite practical, but without a doubt it has great effects on the economy. Obviously whenever the ratio of money compared to actual product is increased, inflation results.[21] As Neale points out “Monetarists emphasise the growth in the money supply in the major world economies as the prime cause of high inflation.”[22] Furthermore, the followers of the Austrian school of economics point out that often this inflation (which sometimes economist try to hide behind the smoke-screen of the ‘business cycle’) is deliberate result of electoral bodies see-sawing the economy prior and after election to increase popular support, whereby a short-term economic boom is followed by financial crises in the long-term.[23]
Even so this could be acceptable if the issuing power (the right to produce money) was in the hands of the public, that is, the elected government. However, the poignant predicament is that the majority of the world’s currency is produced by completely private banks, seeking only their personal profit.[24] To understand this we must understand the role of fractional-reserve banking and how it contributes to the money creation process.
Fractional-reserve banking
The FR system is an age old one. It began when gold-smiths (the first bankers) would store gold for people in their vault and write them cheques in return for their money, since it was easier to carry around paper than bulky gold. The bankers noticed that not everyone would come and claim their gold at once and thus they could lend out some gold that actually belonged to other people. As long as everyone did not come and claim their money at once they would be fine, and would make a handsome profit.[25]
The same system is applied to modern day banking whereby the private banks borrow money from the central bank and then loan it out at interest. This money lent out is in turn deposited back into the banking system which then loans it out again. Although some countries (like the US) enforce reserve requirements[26] in others (like Britain) there is none.
The table below shows how much money a private bank can create with varying reserve requirements.
Table 1[27]
As can be seen from Table 1 even a 10% reserve requirement leads to 90% of the actual money supply being produced by private banks. The worrisome reality is that in Britain “In 1981 the reserve requirements were scrapped. The Bank now relies on the desired ratios of cash and liquid assets to total deposits that commercial banks adopt in their own self-interest... Although the Bank is still committed to act as lender of last resort...”[28] That is banks can lend out as much as they want, with the knowledge that they “cannot lose by lending as much as possible”[29] because the central bank will always bail them out.[30]
As one can see, the control of the majority of the money supply is in the hand of private banks, who can either tighten or expand it, in whichever way profits them most, with complete impunity and disregard for society. The financial crisis now is directly linked to the actions of these private banks, who have been legislated too much power and control. The Islamic solution would be to impose a full-reserve requirement, as suggested by Muslim economists,[31] basing themselves on great western economists such as Milton Friedman, who paraphrased Clemenceau saying: “money is much too serious a matter to be left to the central bankers.”[32]
Conclusion
As we saw there are three key areas of incompatibility between Islamic banking and capitalist banking. Interest, the one usually stressed the most, is not the only one. The move to a completely Islamic system requires an imposition of full-reserve banking and the return of the issuing power of money to the elected government, with the issue of a gold-standard usually added as well, but perhaps not a key factor. Such a transition is not impossible, but, like any transition, will of course be accompanied by some difficulty.
[1] Khan, Waqar Masood, Towards an Interest Free Islamic Economic System, in Mohsin S. Khan and Abbas Mirakhor (ed.) Theoretical Studies in Islamic Banking and Finance
[3] I.e. food is not declared illicit, but rather certain types of food, similarly, inter-gender relations are not prohibited, rather they are restricted to the sphere of marriage.
[4] As-Sadr, Muhammad Baqir, Iqtisaduna: Our Economics, p. 54 He points out that 7th and 9th articles of the Soviet constitution allow forms of private ownership, whilst nationalization of utilities and infrastructure exists in all capitalist societies.
[5] An-Nabhani, Taqiuddin, The Economic System In Islam, p. 75 - 6
[6] Khan, Mohsin S., Islamic Interest-Free Banking: A Theoretical Analysis, in Mohsin S. Khan and Abbas Mirakhor (ed.) Theoretical Studies in Islamic Banking and Finance, p. 20
[7] Neale, Bill, Q & A Questions & Answers: Economics, p. 202
[8] Begg, David, Economics, p. 385
[9] Short for no-income, no-job
[10] These CDS loans were a sort of insurance deal made by big investors such as America Investment Group (AIG), Lehman Bros Co., and Bear Stearns. Essentially it boiled down to amalgamating many safe and secure loans with so called ‘toxic loans’ given to people who had a low likelihood of paying back. This concoction was then sold off as a naked CDS loan (something illegal before the 90’s) to companies that were required by law to have secure rates of return on their investments: for example insurance companies such as AIG that were liable to pay to the public. However, these CDS’s were far from actually being secure, as was witnessed when the ‘housing bubble’ burst (caused by giving out the so called ‘NINJa’ loans that were then amalgamated in the CDS loans) and companies like AIG found themselves massively indebted. For more information see:
http://www.npr.org/templates/story/story.php?storyId=94748529
http://www.dailykos.com/story/2009/3/27/713698/-The-Real-Crime-in-the-BailoutNaked-CDS-Deals
http://www.rollingstone.com/politics/story/26793903/the_big_takeover/print
[13] Khan, Mohsin S., Islamic Interest-Free Banking: A Theoretical Analysis, in Mohsin S. Khan and Abbas Mirakhor (ed.) Theoretical Studies in Islamic Banking and Finance, p. 31
[14] Explained in the pertinent section below
[15] Khan, Mohsin S., Islamic Interest-Free Banking: A Theoretical Analysis, in Mohsin S. Khan and Abbas Mirakhor (ed.) Theoretical Studies in Islamic Banking and Finance, p. 22 -3, 33
[16] Under the Bretton Woods agreement the signatory states had their currencies tied to the dollar, which in turn was based on a gold-standard, that is, the amount of US gold reserves.
[17] Neale, Bill, Q & A Questions & Answers: Economics, p. 232 - 3
[18] Zalloom, Abdul Qadeem, Funds in the Khilafah State, p. 165 - 6
[19] Begg, David, Economics, p. 382
[20] Ibid., p. 384
[21] For example the massive inflation that was caused when the Weimar Republic printed Deutsch Marks
[22] Neale, Bill, Q & A Questions & Answers: Economics, p. 256
[24] The central bank has the role of issuing money and even though the Bank of England is a national institution, the Federal Reserve (the US central bank) is not. The same applies to the European Central Bank, the World Central Bank, the International Monetary Fund, and the Bank of International Settlements
[25] Begg, David, Economics, p. 369
[26] That is how much of the actual capital the bank has to keep in its reserves. In the US this is usually around 10%
[27] http://wpcontent.answers.com/wikipedia/commons/0/01/Fractional-reserve_banking_with_varying_reserve_requirements.gif
[28] Begg, David, Economics, p. 394
[29] Ibid., p. 383
[30] The rare exception being BCCI, which was a bank owned and invested in mainly by Asian Muslims in the UK, which went bankrupt in 1981, but curiously was not bailed out. The reality is that the central bank has complete discretion on whom to lend to and whom not to. See: Begg, David, Economics, p. 385
[31] Khan, Mohsin S., Islamic Interest-Free Banking: A Theoretical Analysis, , p. 33
[32] go.owu.edu/~rjgitter/Milton%20Friedman.doc
Bibliography
· An-Nabhani, Taqiuddin, The Economic System In Islam, London: Al-Khilafah Publications (2000)
· As-Sadr, Muhammad Baqir, Iqtisaduna: Our Economics, Tehran: World Organization for Islamic Studies (1994)
· Begg, David, and Fischer, Stanley, and Dornbusch, Rudiger (ed.), Economics (5th edition), England: McGraw-Hill Book Company Europe (1997)
· Khan, Mohsin S., and Mirakhor, Abbas (ed.) Theoretical Studies in Islamic Banking and Finance, Houston: The Institute for Research and Islamic Studies (1987)
· Neale, Bill, Q & A Questions & Answers: Economics, London: Financial Training Publications Limited (1983)
· Zalloom, Abdul Qadeem, Funds in the Khilafah State, London: Al-Khilafah Publications (1999)
· go.owu.edu/~rjgitter/Milton%20Friedman.doc
· http://www.dailykos.com/story/2009/3/27/713698/-The-Real-Crime-in-the-BailoutNaked-CDS-Deals
· http://www.econlib.org/library/Enc/AustrianSchoolofEconomics.html
· http://www.npr.org/templates/story/story.php?storyId=94748529
· http://www.nytimes.com/2009/03/01/opinion/01ferguson.html
· http://www.reuters.com/article/newsOne/idUSMAR85972720080918
· http://www.rollingstone.com/politics/story/26793903/the_big_takeover/print
