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Principles of Islamic Banking

Prof. Dr. Iraj Toutounchian
Professor of Economics
Az-Zahra University
Tehran Iran

The most powerful force in the universe is compound interest.

Einstein
Capitalistic system, confessed by some prominent economist, is fraught with “many objectionable features”, to use Keynes’s assertion, (1964). While these objections have not been made explicit, nevertheless some of the most important ones are targeted towards interest rate and the ills that emerge from it. Professor M. Friedman has asserted (1969), that zero nominal rates of interest are necessary condition for efficient resource allocation. This is known as Friedman Rule. It was further demonstrated by H.R. Cole and N. Kocherlakota, (1998), that Friedman Rule is not only necessary but sufficient for efficient resource allocation.
Our assessment of capitalism is that rate of interest, (Riba), and its derivatives are economic evils of the system. We can go even further to assert that it is “the prime fallacy” which perpetuates itself to further fallacies. Based on our judgment Einstein’s assertion can be paraphrased to read: The most destructive force in the universe is compound interest. At least one thorough and instructive study was performed by H. Creutz, (1378= 1999), which shows that from every Mark a German consumer spends one-third goes to interest charges. For exposition purpose, assume that every German consumer works nine hours a day. What Creutz’s result would amount to is that each and every German consumer should work three hours a day just to pay the interest charges on the commodities he/she consumes.
3-1: One of the major determinants to attain sustained growth is equitable distribution of income and wealth. It is a well-known finding that there is conflict between efficiency and equity in capitalistic system. Islamic teachings tell us that wealth is not supposed to be concentrated in the hands of a few. To reach this conclusion specific sanctions and guidelines have been introduced to us through Islamic teachings. The conflict is, surely, removed through co-operation in the Grand Co-operative System of Islam.
Capitalism has proven to be incapable to reach above-mentioned goal. Recent statistics about the US economy shows that 1% of the population owns 50% of everything. Additionally, Gini coefficient of wealth is 0.82 which is close to perfect injustice.
3-2: Some Western economists are admittedly, Professor M. Weitzman, among others as mentioned earlier, on the belief that capitalistic economy is unable to increase Aggregate Demand, (AD), and Aggregate Supply, (AS), simultaneously. The reason, not explicitly mentioned in Western literature, being that their monetary and fiscal policies cannot depart from inflation and/or unemployment. In the co-operative system where labor shares part of the profit combined with Islamic banking has, as we believe, the ultimate answer to this long-persisted anemia.
Profit and Loss Sharing (PLS) as a principle and also as a powerful symbol of co-operation constitutes the backbone of Islamic banking. The expansion of this principle throughout the community transforms that community into a large co-operative within which every individual Muslim would try his/her utmost efforts and thereby benefiting others, he/she would gain benefit. This will not only remove but also does not allow conflicts between economic agents to emerge in the first place. Additionally, if the interaction of individual efforts were utilized in a proper manner then the community’s welfare would be high enough not to let these interactions to be mutually exclusive. This is also true of workers’ remuneration through which they can share the profit gained by the Islamic bank’s contracts made with productive firms whose investment projects have been financed. Sharing profit by workers would partially take care of the demand deficiency Keynes was much worried about. PLS also reduces the price of manufactured goods due to two reasons. On the one hand the price decrease is due to the omission of interest (Riba) charges and on the other is due to decrease of wage expenditure brought about by workers’ participation in profit. Pursuing such a policy, accompanied by participation of Islamic banks with productive firms and, further, by proportionate distribution of profits among the depositors, simultaneous achieving an increase of Aggregate Demand and Aggregate Supply will be made possible.
3-3: Distinguishing money, (M), from capital, (K), is not an easy task. This is exactly what Professor Joan Robinson has warned us about so that we do not get misled. In his paper, Toutounchian, (2006), has made an attempt to take the problem one step ahead. Unlike the conventional banking the major task of Islamic banking is to transform M (1) ─ C ─ M (2), where M (2)>M (1), relation to proper C─ M─ C. We believe that it is through this transformation that money plays its most important role as the medium of exchange. In the former relation, a conventional bank plays no role in the economy but being a monetary intermediary. Furthermore, such banks can be described as the ones which start from ΔM and is hoped to lead to change in output,

#916;Q). In an Islamic setting banks are directed towards playing an active role in the economy through PLS contracts and the causality chain is reversed from ΔM→ΔQ to ΔQ→ΔM. In other words, unlike the conventional system in which supply of money is exogenous it changes to endogenous variable in case of Islamic banking. This will incorporate monetary sector into the real sector in order to make a unified system. This seems to be in perfect conformity with the ideas put forward by Professor P. Davidson, (1972), and that of Professor R.Teigen, (1976), both of them assert that the supply of money ought to be made endogenous. In this new model as long as there are justifiable investment projects supply of money can be safely increased without being worried about inflation. Every piece of money coming out of this system is supposed to be project-backed. Specifically, in PLS contract the legal aspect of money, the potential capital, in conjunction with labor, (L), changes to actual capital, K, as shown below: M♀L→ Actual K; where ♀ stands for “legal transformation”.
The proposed system has several important implications briefly named below:
(a) Islamic banks change from being monetary institutions to financial institutions.
(b) The policy followed by Islamic banking is financial policy far from being policy.
(c) Required reserve ration can be lowered safely down to zero.
(d) No other monetary policies are valid here.
(e) The only and the most effective financial policy that shall be followed by Islamic banks are to change the profit ratio relative to the capital ratio put into PLS contracts. This ratio varies depending upon the priorities given to different investment projects with an eye on their impacts on value-added or employment.
(f) Another seemingly strange implication is about the opportunity cost of capital. In the conventional system this cost for all investment projects is the going rate of interest, (r); ignoring some valid objections I have for accounting cost and against economic cost. The existing conclusion is based on the logic that internal rate of return, (IRR= ρ), is independent from the rate of interest. That is the covariance,(Cov.), between r and ρ is: Cov. (r, ρ) = 0 (7)
In other words, rate of interest is always there whether an investor chooses to invest or not and IRR is always compared with a fixed and predetermined rate of interest. With removal of all rates of interest, on any durable commodities and their derivatives, from the system all investment projects become interdependent. This means that covariance between any two projects like i and j is different from zero: Cov. [ρ (i), ρ (j)] = 0; for all i ≠ j (8)
This conclusion has been demonstrated by I. Toutounchian,(1365 = 1988), to be also true for capitalistic system but as soon as money market is deleted from the system, for any one of the investment project it is a matter of “to be or not to be” part of the investment opportunities that an investor chooses from. If, in the conventional system, he/she chooses to be in business his/her cost of capital is the rate of interest because it is the least available return that can be gotten from the money. Whereas, in an Islamic framework the supposition is that “there is no such a thing as a free lunch”. This means that all investment projects compete with each other. Additionally, the IRR of any one project, if chosen, is going to change the entire alternatives open to investors. Whereas in the conventional system, due to monetary market being separated from the real sector, any decision on the part of investors is not supposed to change the rate of interest resulting from speculative activities in the money market. This, further, means that despite the differences in the definitions and terminologies that exist between accountants and economists, [See Iraj Toutounchian (2006)], there should neither be any cost according to economists’ view nor historical cost according to accountants’ point of view. The ultimate outcome is lower price level in the Grand Co-operative system of Islamic economic system compared to that of the conventional one.
(g) All in all, we are going to have three markets in an Islamic economic system. These are labor market,(LL), capital market,(KK), and commodity market, (CC). These three markets in the rate of return and NNP plane can be used in a unified manner to reach general equilibrium in the system. This again is left as an exercise for economics students. With the abolishment of interest, and therefore, money market, the conventional LM curve loses its total validity and becomes not only redundant but also misleading. Money, then, performs its universal function as the medium of exchange but not store of value (or wealth). In this sense we come very close to Adam Smith’s strong assertion that:” money is not wealth” which also corresponds to Professor Soddy’s notion of virtual, not real, wealth. This will provide the underlying logic behind the usual practice of putting “currency held by public” in the credit side of all central banks’ balance sheets. It can be used, in turn, to easily prove the Quantity Theory of Money.
(h) When it comes to the role of the Central Bank in Islamic banking, [See I. Toutounchian (2004)], as was mentioned above no monetary policy tools is valid any more. The unique and powerful tool of financial policy is to determine the share of profit relative to that of capital for all investment projects submitted to Islamic banks. This is, most likely, the most important and unique role of a central bank can play in Islamic banking. There are many factors underlying the determination of this share, especially in the face of natural risk inseparable from investment decision making. This share, if effectively used and monitored, would make banks’ sources of finance being properly channeled into asset building processes of the firms without worrying about money whirlpool from emerging. To determine equilibrium in this market the relative profit rate of the Islamic bank, call it “financier”, on behalf of depositors, to that of the investor, call it the “financee”, can be constructed based on the priority list of investment projects mentioned earlier. The profit ratio of the financier-financee shall not be necessarily the same as their share in capital. This makes the rate a powerful incentive for potential investors. This rate is especially useful in cases where different risks are involved. To prepare a list of different risks involved in various investment projects is another important task of the Islamic Central Bank. The role of the central bank in determining arrays of IRRs for different sectors and various activities is highly valuable in channeling resources into proper projects. After the feasibility and profitability of the projects have been confirmed by Islamic banks’ qualified personnel, the projects become eligible to obtain finance. The projects themselves become collateral for finance. Central banks’ role in providing guidelines about both of these aspects will certainly be appreciated by Islamic banks.
Islamic Central Bank’s task is also to instruct Islamic banks to give priority to those projects which are more compatible with the country’s economic plan. To determine the degree of risk in different sectors and regions throughout the country is the task of research institutions independent from the central bank. However, these risks are to be utilized by Islamic Central Bank which provides a uniform procedure for all Islamic banks for various sectors located in different regions of the country.
If Islamic banks are prohibited to lend on interest and if constant and effective supervision is conducted on a random basis by the Central Bank the chances are very slim a money market, which could be outlawed, to be developed. This is, most likely, the reason Professor Friedman in his paper,(1966), addressing the problem of stabilization policy has advocated the Required Reserve Ratio to be raised to one-hundred percent.
It is hoped the fact was demonstrated that the kernel of Islamic banking is PLS. Nonetheless, different modes of contracts are also available as auxiliary to finance needs of both firms and individuals upon their proper requests. By preparing accurate information and making them available to the general public, Central Bank in Islamic setting would be able to provide symmetric information and, thereby, to prevent moral hazard to a great extent.
Let me admit that the monitoring cost of Islamic banking compared to that of the conventional banking is relatively high. However, the potential benefits as to its strong impact on reducing unemployment and keeping prices constant would undoubtedly overshadow the cost. Most important of all, distribution of income and wealth is expected to be more equitable than otherwise. Such a scheme of distribution guarantees sustained economic development. With the abolishment of interest and the absence of any expectations as to its future trend induced by speculators in the money or any other durable good markets provides a counter-cyclical environment in the system. These advantages have received little, if any, attention. More research is needed in this area. Most, if not all, Muslim scholars have concentrated on how to remove interest (Riba) from the system to the neglect of above advantages. Thus, these recommendations are hereby offered to be put in the forefront of the agenda for further investigation. While many profound researches have been undertaken by competent scholars, we still have a long way to go.

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