On some viewpoints of Tarek El Diwany about Islamic Finance

Jan Aldert Bergstra

Utrecht, The Netherlands,

A most useful site on Islamic finance is being maintained by Tarek El Diwany from London on http://islamic-finance.com. Tarek El Diwany is also heading Zest advisory LLP (http://zestadvisory.com), which provides consultancy on matters of Islamic economics to a wide range of institutional clients.

Without making any attempt to provide a full survey of Tarek El Diwany's viewpoints regarding Islamic finance, which have been laid down in several books written for the international market, I will reproduce a number of intruiging positions, taken from his contributions on http://islamic-finance.com. These positions are definitely relevant for the RPSF line of investigation (see "Preliminaries to an Investigation of Reduced Product Set Finance, http://arxiv.org/abs/1012.4291). Of course the responsibility for mistakes that may perhaps be perceived in the interpretation of Tarek El Diwany's texts below is entirely mine.

In a previous post on this blog, Bergstra & Middelburg http://introductiontorpsf.blogspot.com/2011/01/product-instance-assessment-for-rpsf.html

we have assumed that writing about Islamic finance from a non-Islamic position constitutes an additional difficulty, in comparison to writing from an 'inside' Islamic position, and for that reason requires additional scrutiny. Tarek El Diwany, however, provides arguments for an opposite point of view by means of the following six observations.

Observations made by Tarek El Diwany

1) Christianity opposed interest payment successfully until the contractus trinus was introduced in the 13th century. Contractus trinus (a description can for instance be found in http://arxiv.org/abs/1012.4291 based on a paper by Wolters) provides a synthetic financial product composed from permissible base products (from a medieval Christian viewpoint) which for all practical purposes can be equated with an interest bearing loan. According toTarek El Diwany the Church was unable to prevent the use of contractus trinus by legal means, although it initially had an intention to do so. As a consequence "Christian" financial engineering (in particular financial product synthesis compliant with Christian regulations as issued by the Church in those days) during the 13th century, put an end to the resistance of the Church against the use of interests. Since that time Islam is the only remaining force against interest based finance.

2) In the first half of the 20th century Islamic economics and its subtheme Islamic finance (IF) emerged. By now that has led to an activity which may be referred to as mainstream Islamic finance (mainstream IF). According to Tarek El Diwany mainstream IF's greatest strength, however, lies in sophisticated financial engineering leading to synthetic products that simulate 'unethical' products by making clever and combined use of ethical financial products only. He then proceeds with the observation (without supporting proof or documentation) that mainstream IF methods play a role comparable to the role played by contractus trinus. Due to mainstream IF many inhabitants of originally Islamic countries (that is countries with Islamic majorities) now are in debt (possess negative equity) with obligations imposed upon them that are hard to distinguish from the hardship of interest payment. Thus rather than to keep interest prohibition in tact, mainstream IF has had the opposite effect of exposing the Islamic population of a number of countries to new and seductive financial arrangements of which the disadvantages will become manifest only much later.

3)Tarek El Diwany leaves no doubt about his viewpoint that the relevance of interest prohibition needs to be understood from the problems that will creep into any system without interest prohibition. This is a fundamentalist approach as it is grounded on a perspective concerning the original motives that led to interest prohibition. Stated differently, rather than demanding formalistic Shari'ah compliance, he demands the awareness that interest based finance brought, brings and will bring many citizens into deep trouble by exposing them to the risk of negative equity from which they may not be able to escape. These problems are linked with the practice of fractional reserve banking. Formalistic adherence to the tenets of mainstream IF need not guarantee the disappearance of such problems. According to Tarek El Diwany fractional reserve banking must be considered inadmissible from an Islamic point of view because it features gharrar. In this case gharrar refers to the downside risk of a bank run which may terminate the bank's existence. Expecting the non-occurrence of the bank run may be considered a matter of maisir (a gamble).

4) Taking a closer look at fractional reserve banking, suppose that bank B obtains 1 M Euro additional reserve by client deposits, and according to the regulations it may now lend k M Euro to its clients (thereby creating (k-1) M Euro), who annually need to pay i.k M Euro interest to B, of which i.(k-1) M Euro for newly created money. First of all B leaves it to external parties to produce i.(k-1) M Euro and secondly these (k-1) M Euro which have been created are probably deposited after certain transactions from B's clients with third parties on other banks for which these third parties are clients thus triggering the additional creation of (k-1).(k-1) M Euro and so on. Banks create additional money because they can lend it with interest to their clients. This whole mechanism may lead to a perverse feedback cycle on a real estate property market where the newly created money triggers in increase in property value which may become a self-fulfilling prophecy thus leading to an overvaluation and a consequent collapse of property values that finally leaves many property owners in negative equity. Fractional reserve banking plus interest based finance can lead to a financial chain reaction within an overheated financial multi-processor (the rational banking system) with a subsequent and very detrimental melt-down. Such difficulties, which are not hypothetical, can and must be prevented by Islamic based interest prohibition. 

But analyzing from the perspective of rational finance Tarek El Diwany concludes (already in a 2004 contribution) that it would be most useful to include home prices in the calculations that determine inflation so that a boom in property values can lead to either increased interest rates or to higher reserve requirements for banks. This is very convincing, recent history having amply confirmed this position, and one might add that even the stock marked must be taken into account when determining inflation because most people buy stock (themselves or indirectly via pension funds) in order to guarantee an appropriate income after retirement. They have no other option than to make such investments.

5) Having thus reiterated the problematic character of money creation by banks in combination with an interest based system of financial circulation, Tarek El Diwany comes to the drastic and unexpected conclusion that mainstream IF has imported these problems and the consequences thereof in a number of countries where such problems were far less prominent before mainstream IF came into existence via Islamic windows of mainly internationally operating western banks. Here one notices a point that makes the understanding of Islamic finance much harder from an Islamic point of view, than from a non-Islamic point of view. As an outsider one need not really be worried about the Halal status of mainstream IF. But from inside Islam that issue cannot be avoided and positions like that of Tarek El Diwany need to be taken into account. 

The PPSF paradox

Implicity Tarek El Diwany points to a paradox. I will call this paradox the RPSF Paradox: limitation to a reduced product set can trigger exactly the consequences (here widespread negative equity with highly adverse consequences for its holders) that this very limitation is supposed to prevent.

6) Tarek El Diwany further notices that mainstream IF providers make use of small teams of Islamic scholars as consultants who can judge positively about the Shari'ah compliance of their new financial products even if these scholars know that a majority of their colleagues would oppose a positive judgement. He notices, however, that Islamic jurisprudence asks these providers to be autonomously convinced about the Halal status of their products and that the legal process is primarily needed to establish a Haram status once the Halal status of a product comes under attack. This attack can take place in spite of the provider's conviction that the product is Halal, which in any case is assumed to have been arrived at in good faith. Opponents to a product need to prove their point, and that is the other way around compared to what mainstream IF providers seem to be doing. According to Tarek El Diwany this mechanism for positive evaluation tolerates ignorance concerning deeper Islamic objectives and the usage made of the mechanism results from a lack of commitment by the management of mainstream IF service providers to the intrinsic objectives of "true" islamic finance.

A paradox of fundamentalism

A most remarkable corollary of Tarek El Diwany's position is this: he advocates a stricter application of some Shari'ah based constraints (no gharrar for banks, avoiding negative equity for citizens) than mainstream IF's advocates and that makes him a hard-liner from a non-Islamic perspective. But at the same time he is less formalistic or dogmatic in his approach to the application of Shari'ah principles than mainstream IF providers who (according to Tarek El Diwany) use their strict and uncompromising attitudes as a marketing strategy towards a naive Islamic customer base that is likely to mistake these strict attitudes for an intrinsic compliance with Islamic principles. By having essentially social objectives, for which Islamic finance serves as a means to an end rather than as an end in itself, Tarek El Diwany is more inclined to take rational finance (that is "conventional finance") solutions seriously into account and to remedy the problems created by such solutions by means that may not fully but at least partially be in compliance with his understanding of Shari'ah constraints. Summing up: his drastic orientation towards some Islamic virtues induces a more compromising attitude towards some aspects of rational finance. At first sight this is paradoxical and the paradox results from taking an inside Islamic position. This second paradox (counting the RPSF paradox as the first) is absent for observers from outside Islam. Extrapolating perhaps beyond Tarek El Diwany's own position I obtain the paradox of fundamentalism in Islamic finance which consists of these two rules:

(i)  a more fundamentalistic approach to Islamic Finance is likely to be more compromising towards rational finance,

(ii) a more dogmatic (and for that reason less fundamentalistic) approach to Islamic finance tends to be less compromising towards the achievements of rational finance.

Conclusions and further remarks

Each of the above 6 observations impacts on the research questions that were put forward in previous contributions to this blog. At the same time the line of argument need not be accepted as compelling by a non-Islamic researcher of Islamic finance who at least initially can study mainstream IF as if its claims to Halal status have been established beyond reasonable doubt. For a non-Islamic observer both paradoxes (RPSF Paradox and Fundamentalism Paradox) are mere curiosities. A non-Islamic observer only needs to take into account that Islamic finance includes a range of subtly disparate judgements about the relative and absolute ethical status of the same financial products, where some approaches claim "true IF" status in opposition to mainstream IF status which is then considered less "true".

Following Tarek El Diwany's line of argument no instance of RPSF is the right way to go because probably no approach to it can guarantee that its application on a large and complex scale will prevent the negative consequences of interest based finance.  


Some arguments can be put forward against these opinions. Islamic finance may be considered a very successful and imaginative exploitation of a far from trivial insight (probably due to Maulana Mawdudi and his coworkers around 1930): simply by imposing the prohibition of interest payment in a rather strict way an entirely new financial industry can be launched. This industry will bring modernity (imperatively needed according to Mawdudi) to Islamic states but it will do so in an Islamic fashion. "Islamization of modernity" has been coined as a label for this perspective. Islamization of modernity might be contrasted with modernization of Islam which Mawdudi considered less promising. Eighty years later Islamic finance proves vividly that Islamization of modernity can make sense. Tarek El Diwany, however, puts forward that he is not a fan of the particular form of modernity (modern banking) which has now been imported on a grand scale in Islamic countries as a consequence of the emergence of Islamic finance. Where he considers Islamic finance a tricky detour for moving barriers out of the way that were previously successfully imposed, Mawdudi's  successors are more likely to be surprised by the remarkable Islamic identity which their new banking system has acquired and which it seems to maintain without any problem. These matters are the more confusing because Mawdudi is sometimes considered to have been an intellectual forerunner of Islamic extremism. At the same time his heritage can be blamed for importing more western methods and techniques into the operations of Islamic countries. My conclusion is that Islamic finance represents the impact of a striking achievement of visionary clear thinking given the objective of Islamization of modernity, on which Tarek El Diwany's critique has no bearing. Tarek El Diwany's critique, however, goes at the heart of the rationale of Islamization of modernity as an objective, because he hopes instead that the Islamic world can learn from "western mistakes" and that known design errors in societal engineering can be avoided by means of a more principled approach.