Friday, December 23, 2005

Islamic banks and the Bedford Falls Savings and Loan 

Kurt Peters at Writing History writes me.
Just watched an interesting round table about the future of Iraq on Cspan. One of the panelists talked about the effort to establish an Islamic economy. I know very little about economics other than I never seem to have enough money. I do know that economic practices set down by the Koran differ from Western style economies. Do you know what they are and could they work in a globalized world?
That question has interested me for a long time, as I went to graduate school during a period when many schools were loaded with students from the Middle East, sent by oil-rich governments looking to build a generation of technocrats. I had many discussions with them about usury. Kurt's email got me to looking around for the state of play in Islamic finance, and luckily a new article in Finance and Development covers just that.
Islamic financial products are aimed at investors who want to comply with the Islamic laws (Sharia) that govern a Muslim's daily life. These laws forbid giving or receiving interest (because earning profit from an exchange of money for money is considered immoral); mandate that all financial transactions be based on real economic activity; and prohibit investment in sectors such as tobacco, alcohol, gambling, and armaments. Islamic financial institutions are providing an increasingly broad range of many financial services, such as fund mobilization, asset allocation, payment and exchange settlement services, and risk transformation and mitigation. But these specialized financial intermediaries perform transactions using financial instruments compliant with Sharia principles.
There is an obvious parallel, to those familiar with financial history, to the prohibition against usury in the Church of medieval times. The drive for development led to the use of Jewish families as bankers. In the Ottoman empire of the 19th Century, the rulers relied on Jews and Armenians as proxies to negotiate loans from Europe (such loans were further helped by the lenders' recourse to secular courts based on Napoleonic rather than Islamic jurisprudence.)

Modern Islamic banks use a variety of instuments as described in the article to allocate risk of a project where the time money is put in and the time revenues are paid out differ. Islamic finance has a rather keen understanding of the nature of investment and creates instruments that allow participation at several different levels. But it has two problems that strike me as difficult to overcome. First, banks develop means of managing liquidity -- the ability to meet deposit outflows like the bank run you probably watch this weekend at the Bedford Falls S&L in It's a Wonderful Life. It does so by storing some of its deposits in debt instruments. In It's a Wonderful Life, the liquidity instrument is the money for the honeymoon that Donna Reed pulls out of her coat. These instruments don't exist well within Islamic finance, unless you think of oil revenues as being the money in Donna's coat. This prevents banks from growing very large; even when they do, they have to hold so much cash in the vault 'just in case' that they are rather unprofitable.

Second -- and on this point I invite comments because I am very interested in it and I am just barely past the point of pure speculation -- there seems to be a strong antipathy in Islam towards profit. It runs similar, in my basic understanding, to the Church's debate over just price and just wages -- how much should that doggy in the window cost? Over time the less free interpretations of the just price gave way to our modern understanding, culminating in Adam Smith. It does not appear that Islamic thought has made this advance yet. That the history of economic development of the world between 500 and 1500 AD was more Islamocentric than Eurocentric, and that it was at the end of that period that period that the just price debate began to be resolved, may be a coincidence, or it may be much more.

So what is holding Islamic economies back has existed for centuries in this view, and while some steps are being made, there is nothing less than a paradigm shift needed for those countries to gain the same level of economic and financial development.