Monday, July 18, 2005

As much discussion of Islamic Banking as I could manage

Marco appears to have made the assumption in our discussion of a hypothetical future caliphate that such a state would be economically uncompetitive compared to states organised economically along Western lines. I don’t know that this would neccessarily be the case. It was manifestly not true twelve-hundred years ago, before Dar al-Islam broke up into feuding states. The trade of China and of West Africa was handled by merchants based in the caliphate. The hoards of silver that they keep digging up in Scandinavia are all Arab coins. Is there anything intrinsically inferior about an ‘Islamic’ economic system, or has it merely stagnated while continual developments have been made in the West?

Let us consider the options open to me with my superannuation fund. I can put my money in a low-risk, low-return fund based on usurious principles of traditional Western banking, or I can put it in a high-risk, high-return fund based on the principle of shared risk- that is, the provision of capital for entrepreneurial activities-much like the mudaraba contract of a traditional Islamic bank. Surely the fund with the higher rate of return is ensuring the more efficient use of capital? A modern banking system organised along Islamic lines should encourage the use of capital in productive ways, rather than for the purchase of static assets in the hope that they will appreciate in value. I have just been reading a book- “Islamic vs. Traditional Banking: Financial Innovation in Egypt”, by an economist with an armenian name based in Sweden- which is why I know that mudaraba word, which says there are clear theoretical advantages of Islamic banking, especially in developing countries:

(1) Riskier, longer-term investments are promoted, providing a greater incentive to adopt new technologies.

(2) The absence of a requirement for collateral increases the demand for investment capital.

Practically, the book concludes that Islamic banks in Egypt have performed poorly, but largely because they have not exercised their mandate to invest in long-term, higher-risk projects. In fact, they have not even been particularly Islamic in their investments, depositing most of their funds in traditional banks overseas.


Dave said...

Interesting. In theory, this - high risk investment in long-term research/development projects, and the like - is an approach I feel like I could come to heartily embrace.

Is there any evidence of this approach to investment actually occuring in the Arab states (the economically successful ones or otherwise)?

Marco said...

I disagree with this analysis in a number of ways, but for the moment, let me say that there is a well known tradeoff between risk and returns. This is true for all types of investments (both as a rule of thumb, and statistically) That is to say that a higher return is generally an indication of riskiness, all other things being equal. Long term investments are inherently risky only because our predictive models work better in the short term. These facts tend to flatten any possible benefits available by investment choice type (ie. risky vs safe, high yield vs low, and short term vs long). The rest is about luck (or God's will if you must) most economists recommend a balance between investment types across an entity, some entities being too conservative and others being to speculative.

This is the word of "The Economist" :-)

Anonymous said...

Dr.Clam, you seem to know more about Islamic banking than I do. What puzzles me somewhat is your emphasis on high risk long-term investments. From what I read, excessive risk is not permitted in Islamic banking. But of course, this depends on how you define "excessive". An essential characteristic of Islamic banking seems to me the prohibition of "unproductive" speculation (money chasing after money, without productive investment).


Dr. Clam said...

My understanding is that there is nothing as 'safe' as lending at interest in proper Islamic banking. You contribute something (either capital or labour) to a productive activity in the real economy, with an eye to contributing in the profits. If you are an ordinary depositor, the bank does this on your behalf. But the ship might sink, or locusts might eat the crop, or the vendor might kick over the tray of vases with his foot... so it is inherently higher risk and longer term than lending at interest. Under this model, I expect it would be more difficult to get finance for 'high risk' entrepreneurial activities: under a usurious regime, the entrepreneur still has to pay the bank back if the venture fails, but in an Islamic system they have both lost, so the bank would prudently stick to the safer parts of the productive economy. On the plus side, this would make it easier for failed entrepreneurs to dust themselves off and start over, and I understand such people are major drivers of development.