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Sami Al- Suwailem IRTI, IDB Thul - Qida 1430H –November 2009

Introduction to Islamic Finance. Sami Al- Suwailem IRTI, IDB Thul - Qida 1430H –November 2009. Outline. Pillars of Islamic Finance Non-profit Domain For-profit Domain. The Two Pillars of IF. For-profit domain Non-profit domain A balanced approach.

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Sami Al- Suwailem IRTI, IDB Thul - Qida 1430H –November 2009

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  1. Introduction to Islamic Finance Sami Al-Suwailem IRTI, IDB Thul-Qida 1430H –November 2009

  2. Outline Pillars of Islamic Finance Non-profit Domain For-profit Domain

  3. The Two Pillars of IF • For-profit domain • Non-profit domain • A balanced approach

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

  5. Brotherhood • Brotherhood replaces both individualism and communism • Brothers are similar enough to promote sympathy and cooperation • But they are different enough to allow for specialization and trade • Brotherhood encompasses both domains

  6. Non-proft Domain

  7. Non-profit Institutions • Zakat • Nafaqat • Inheritance law • Sharing in times of necessity, starvation, or hardship

  8. Zakat • Obligatory donation • Applies to idle money (not used for one year) • Measure against hoarding • Hoarding and the current financial crisis?

  9. Nafaqat • Obligatory spending for designated relatives • Parents, family, close relatives • Subject to need

  10. Why Non-profit Institutions? • Coordination • Civil standards • “Tragedy of the commons” • “The whole is greater than the sum” • Safety net • Less moral hazard than government net • Preservation of wealth

  11. Why Do We Need Both? • Happiness cannot be achieved by one domain • Balance allows both to flourish and thrive

  12. For-proft Domain

  13. General Principles • Prohibition of israf • Prohibition of usury or riba • Prohibition of gharar or wagering

  14. Israf • Over-spending or over-utilization of resources • In consumption: • extravagant spending • Conspicuous consumption and status games • In investment: • Greed—“Irrational exuberance” • Bubbles => crashes

  15. Wealth Preservation • Wealth preservation is an essential objective of Shari’ah • Israf violates preservation of wealth • Results: pollution, global warming, depletion of resources • Essence of economics is to avoid israf

  16. Riba

  17. Definition • Riba or usury: any stipulated addition over a loan • Includes both simple and compound interest

  18. Riba • Prohibited by all divine religions as well as Buddhism • Two-thirds of world population subscribe to this belief

  19. What's Wrong with Riba? • Debt grows faster than wealth • Debt cannot be paid except with new debt • Debt burden destroys the economy

  20. 1000 1,546,318,920,731,950,000,000 60,806,303,788,323,700,000,000,000,000,000 1500 2,391,102,204,613,620,000,000,000,000,000,000,000,000,000 2000 $1 Borrowed at 5% in 1 AD

  21. 1 pence borrowed at 4% in 1 AD In 1750 debt equals weight of the globe of gold In 1990 it equals 8190 globes!

  22. Debt in the US, $billions

  23. Figures • Average growth annual rate: • Debt: 39%, • GDP: 21%, • M2: 19% • Debt-GDP ratio: 1.3 to 2.2 • Debt-M2 ratio: 2.2 to 4.2

  24. Inverted Debt Pyramid Debt Wealth

  25. Financial Instability • Inverted pyramid is not sustainable • Crashes needed to “clean up” the system • Then debts start to accumulate again faster than wealth • Recurrent crashes • Very costly to maintain the system

  26. Restrictions on Debt • Theory: Intertemporal Budget Constraint: • The present value of debt go to zero • Prevents Ponzi financing • Reality: E.U. requirements: • Deficit < 3% of GDP • Debt < 60% of GDP • Problem: Need to govern debt from the ground-up

  27. Islamic Finance • 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;

  28. Deferred Sale • Sale of a good for a deferred price • Price includes markup • Time value is paired with real value • Murabaha: Financing deferred sale

  29. Salam • Opposite of deferred sale • Price is spot; good is deferred • Time-value is reflected in lower price

  30. Trade vs. Loan

  31. Principle of Similarity • Similarity negates gain from trade • Variety allows mutual benefit • Diversity is essential for prosperity • Stronger similarity imposes stronger restrictions of exchange • Riba: imbalanced exchange of similars

  32. Loan Trade Similarity Low High High value Low restrictions Low value High restrictions

  33. Normal Debt Pyramid Debt Wealth

  34. Forbearance • Creditor must forbear if debtor is in difficulty • Why forbearance is important for stability? • Foreclosure causes prices to fall • Which leads to additional defaults • Which leads to more foreclosures • Which makes prices go even lower • And so forth

  35. Economic Cycles Unregulated credit expansion Regulated credit expansion Forbearance enacted No forbearance

  36. Conclusion: Nature of IF • Universal principles • Sound economic reasoning • Balanced approach

  37. Thank You!

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