Thursday, April 14, 2011

Form vs. substance or pragmatism vs. idealism?

Last Saturday I attended and spoke at the Berkeley Islamic Finance Forum. It was a good event, although the number of topics and subjects seemed a bit cramped for a 1-day event. However, I suppose that is a good problem to have (more thought provoking than some of the for-profit conferences I have attended). I don't take good enough notes to provide a full overview of the conference and that would likely be rather boring as well, so I'll just have to stick to sharing some thoughts that I had from some of the speakers' presentations.

The overarching theme that got me thinking at the conference was the form vs. substance debate in Islamic finance. Specifically, does Islamic finance need to offer something completely different in economic outcome from conventional finance or is it ok for products to be offered that are Shari'ah-compliant (in so far as the scholars decide they are) even if they replicate conventional products?

The frequent criticism of Islamic finance is that it just offers a financially engineered alternative to conventional finance. When one looks at the economic outcome of most of the Islamic finance products, the criticism makes sense. The products create cashflows that mirror conventional products, although the form of the products is different. The critics use this as evidence that Islamic finance is nothing more than conventional finance repackaged to pass the Shari'ah boards' approval process.

However, there is some nuance that they miss in this analysis. First, many Muslims (rightly or wrongly) will not use conventional products and will use Islamic products, even if they cost more. Perhaps there is some slick marketing that leads to this, but there may not be for many consumers of financial products. However, that leads down a line of discussion that I am not qualified enough to offer an opinion (specifically, whether the structure of a product to avoid interest per se is permissible or not).

That is also more of an academic argument than I care to engage in on Islamic finance. The situation exists that some Muslims demand an alternative to interest-based financing and there are institutions that cater to this need and those institutions are governed by regulations mostly created with interest-based financing in mind. The parts of the economy that are not governed by those regulations don't offer interest-based financing and operate differently.

After that rather long-winded introduction, I think that Islamic finance operates the way it does today because of what is demanded and what is allowed within the regulatory framework which exists today. Islamic banks do what they are permitted to do, which in most countries is debt-based financing. The structure is modified to be murabaha or ijara instead of interest-based lending to comply with the Shari'ah restrictions. Investment companies offer products like mutual funds using what could be compared best to a mudaraba or wakala structure. Private equity and venture capital companies take direct equity stakes (mudaraba or musharaka), and add in some Shari'ah-compliant debt financing to juice their returns. Leasing companies do what they do with ijara and appoint the tenants as their agent to perform the maintenance.

Outside of Islamic finance, companies are set up as joint-ventures or rely on angel financing (mudaraba and musharaka). They are not connected with Islamic finance except perhaps as consumers of the financial products they need like murabaha-based trade finance, ijara or istisna'a finance for capital expendituress and wakala for investing surplus funds and pensions that invest in stocks (mudaraba). People and businesses need to protect themselves against future risks (using takaful).

The point is that the economy as it works does not impose needs on Muslims any different than other economic actors. These needs fall into a couple areas that are met by different types of institutions that specialize in that area of finance. Banks provide trade finance and can intermediate between diverse depositors into specific projects to generate returns and they specialize in managing credit and liquidity risks. Leasing companies are focused on the ability to own equipment where they can make a profit on leasing equipment and selling used equipment after the lease ends. Mutual funds provide specialized investment management services on behalf of others. Takaful companies provide insurance against an unknowable future. Venture capital and angel investors (as well as entrepreneurs working with their own funds) provide financing to businesses.

At what point are these essential needs different for Muslims and non-Muslims? I don't see any; I see the substance of the transactions as identical. The Shari'ah screening provide a form of prudential regulation of the relationship between the parties in transactions and try to avoid areas where one party can take unfair advantage of another. It cannot prevent speculative bubbles because people are always subject to the same fear and greed that leads to bubbles and busts.

The form versus substance argument is mostly a pragmatic versus idealistic argument and I see beneficial points on both sides of the argument. However, the Shari'ah screening is mostly present on the pragmatic side of the equation: finance. Very few companies would on their own decide to hire a Shari'ah board to decide if their partnership were Shari'ah-compliant. If venture capital was prevalent it might, but it is still nascent.

Islamic banking in particular has been singled out for not using more profit-sharing structures and instead relying on debt-based Shari'ah-compliant alternatives. However, if a bank were using the profit-and-loss sharing structure, it wouldn't be a bank as banks are conceived of today. It would be a venture capital partnership. Islamic banks are on the one hand forced to make sure they don't lose depositors' money and also generate a profit on these funds (and profits to their shareholders). How are they supposed to provide daily liquidity and capital protection if they offer equity products on the other side of the balance sheet?

Maybe the idealists are expecting the whole concept of banking as we know it to fall by the wayside and be replaced by venture capital-style financing. Perhaps it is the second coming of the economists who promoted import-substitution economics. If you think the existing order is not done in a way that supports what you want to see, then you should create a complete substitute to it. However, that idea did not work; in fact, it created white elephants across the developing world. Industries designed to substitute for foreign imports operated inefficiently to support an idealism that everything can remain self-contained.

I don't mean to condemn the idealism of those who want a profit-sharing financial system, but based on the needs of financial consumers, the idea of creating a totally parallel system that avoids on principle any conventional banking structures is far fetched. In some situations a debt-based financial product is superior for consumers (if it is sufficiently regulated) to an equity product. That doesn't mean it has to be interest based per se. However, it has to have the same characteristics as interest-based debt (periodic payments, fixed term, redeemable on maturity at par or amortized across the length of the loan). Equity products are superior in others (and are used widely across the financial markets, conventional and Islamic).

My point is not to say that Islamic finance is something that is either doomed to forever trail behind conventional products or that it can't succeed if it differs from conventional finance. It is that the Shari'ah restrictions placed on Islamic finance should be taken as a form of prudential regulation that can protect the Islamic financial system if they are not stretched too far. They also provide the basis for other changes to conventional products that make whatever product offered more fair to consumers. In the wake of the financial crisis, where many, many consumers were abused by the financial system--not just by debt--there is a fairly low bar for an industry to step forward that can provide the same types of products in a more ethical way. This "more ethical way" should be the focus of Islamic finance. Some institutions may focus on different products (debt with banks, equity with venture and angel capital, mudaraba with mutual funds), but they should focus on offering a better product, not something completely different.

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