Jan Aldert Bergstra and Kees Middelburg
(The Netherlands 2011)
Islamic finance: beyond technical product analysis
In [BM2010] we have outlined RPSF (reduced product set finance) as a paradigm that can help to understand ethical finance, and in particular Islamic finance, from the perspective of rational finance (often referred to as conventional finance, see also [BM2011a]). The technical contribution of [BM2010] is to put forward a line of research which can help to understand that exactly are the features of a financial product that make it unwanted from a certain ethical point of view. It is demonstrated that already in the simplest case of a savings account it is far from obvious what precisely triggers the application of anti-interest rulings to that particular case. Technical work as suggested in [BM2010] needs to be performed for all financial products that are considered unwanted in some world view based financial system (see [BM2011a] for that notion), in order to understand precisely what constitutes the offense and to what extent the same objectives can be reached by synthesizing the unwanted product from acceptable products by acceptable means of composition.
Now one might claim, as many authors on Islamic finance seem to be doing implicitly, that it is more or less clear which financial products are in violation of Islamic principles. Based on the work reported in [BM2010] we have doubts about such claims in the first place, but more importantly we believe that such claims render the theme of Islamic finance far more problematic, as a topic of investigation, than it would be, were no such bold claims be made. A simpler view arises if one takes the governance structure of a system of Islamic finance as a point of departure. The theme is simplified if at least in principle the existence and even the co-existence of different systems of Islamic finance can be imagined. In that case one may consider the design of a system of Islamic finance and suggest minor modifications to it without entirely leaving the class of Shariah compliant financial systems. The situation can be compared to someone who investigates a specific programming language say Ada. Even if Ada is his sole subject of investigation, it may be very useful for this researcher to have the notion of a programming language available because that allows him to understand Ada as a particular design existing in the context of a multitude of similar possible (and sometimes actual) design alternatives.
A two tier governance system for Islamic finance
Below we suggest a simple two tier governance system for an system of finance which allows sufficient freedom for tailor made design and which at the same time reflects the stated objectives of Islamic finance to a reasonable degree.
A managed system of Islamic finance (MIF) provides local Shariah councils as well as a general Shariah council. The task of the general council is to set rules that each of the local councils will comply with. Such general rules will explain which financial products are at all available (that is permitted) and which ones (taken from the offerings of a system of rational finance) are not.
Local Shariah councils produce advice on the actual use of available financial products by parties involved. So rather than making assessments at the abstraction level of financial products they deliver assessments at the level of product instances. In practice that means that, if two or more partners intend to make use of a financial product which has not been categorically ruled out by the general council, and they are in any doubt of the ethical validity (in this case Shariah compliance according to the local Shariah council), they ask the local council for an assessment of their joint plan of use of the product. Typically if a poor family plans to bet all of their precious savings on a lottery in order to buy a new home when winning, the downside risk (gharrar) involved may induce the local council to advice negatively against this plan, even if the lottery by itself has not been forbidden by the general Shariah council. If, however, a rich family plans to participate in that same lottery for the same amount of money, but now with the plan to buy the poor family their home when winning, this may be (but need not be) considered permissible because the downside risk is marginal for the rich family.
This two tier arrangement has the remarkable property that it contains rational finance as an extreme case. To see this we assume a MIF where the general council departs from a managed system of rational finance (MRF) and then decides for each of its financial products if the product is unproblematic (all uses are always to be considered ethically correct), forbidden (no usage is ever to be permitted), or problematic. Each instance of the use of a problematic product needs to be assessed by a local Shariah council. If we now assume that no products are declared forbidden at the general level and all local Shariah councils allow for each instance of the use of each problematic product, a system is obtained that differs little from the underlying system of managed rational finance.
This reconstruction of the underlying system of rational finance in the two tier governance model suggest that, unless all problematic products (as ruled by the general council) are always disallowed by al local councils, Shariah compliance of a financial system with this governance model needs to be assessed at a system level. In any case one may allow for local variation in the assessments made by the local councils. Moreover a continuum of possible though hypothetical financial systems emerges in which the most restrictive orthodox system is placed at one extreme and the underlying system of rational finance is positioned at the other extreme. Three degrees of freedom, mainly to be used by the local Shariah councils determine an MIF in this setting: (i) which product instances of problematic products are nevertheless considered ethically valid, (ii) what is to be done if parties engage in a product about which a negative advice has been issued, (ii) what to do if after a transaction (all or part of the progression that constitutes the use of a particular financial product) has taken place, a delayed assessment suggests that the parties involved should not have done so at all.
The advantage of this two tier governance model for a conceptual investigation of Islamic finance are enormous. Although asking for, receiving or paying interest is considered problematic, the local council may allow for it in some cases, and although gharrar must be avoided the determination of gharrar may involve all knowledge of the facts at hand to the local council's satisfaction. Similarly, the local council may decide in which cases inappropriate force is applied to make someone pay or in which cases seller and buyer in a spot sale have failed to exchange sufficient information about the sold item. It is also left to the council to decide if an item at sale is sufficiently real to be appropriately sold. The local council can make up its mind about the impact of the obligation to distribute zakat (gifts for those in need) on the permission of other transactions. It can also assess whether or not an action leads to the exposure of excessive luxury. Finally employer-employee relationships can be assessed concerning the way in which employees are facilitated to fulfill their ritual religious obligations.
The degree of freedom that arises for a Shariah council by being able to permit specific plans of usage of problematic financial products supports the viewpoint that the financial system is providing a means to an end rather than that it constitutes an end in itself. The deeper end to which the financial system is to be tuned relates to the justness of society and the fulfillment of religious duties by all local Muslims in such a way that jihad in the sense of living in an exemplary style which proves the universal value of Islam to others, notably to local non-Muslims, comes to fruition.
Local Shariah council assessment benchmark suite
Viewed from the perspective of the underlying system of managed rational finance these explanations are still vague. One cannot imagine on the basis of this brief explanation how life in the MIF at hand will actually be like. That can be done, however, by developing an extensive benchmark of test cases. This benchmark consists of a listing of plans for the use (or the continued use) of a problematic product together with an explanation of what it is that each of the prospective participants intend to achieve. Now rather than merely responding with yes or with no, the council is asked in each of these cases to respond to the following question: given the intention of the parties as stated what is your advice? There may be the following options: (i) go ahead, the plan is ok, (ii) at least one of the participants has ethically invalid intentions, so don't go ahead, (iii) the intentions of the participants are ethically valid but their plan is not, in the case of these intentions they are suggested another plan that is considered ethically unobjectionable.
Considering the case of interest prohibition this point of view opens up new possibilities. In rational finance the payment of interest combines the compensation for an insurance policy taken by the lender against the failure of the borrower to return the principal amount at the end of the period of lending with a compensation for the opportunity cost incurred by the lender of not having the principal sum available during the period of the loan. One may contend that only the latter amount constitutes an unethical transfer of money, as it provides a certain increase of the principal amount for which no further investment or activity from the side of the borrower is required. A local council may now allow for some instances of loans with interest payment which compensate the lender for the risk of borrower failure only. In this way it scrutinizes the inherited usage of the term interest as well as its payment, thus avoiding an overly restrictive policy which may lead to adverse consequences that jeopardize the whole endeavor of this particular form of ethical finance by inadvertently ruling out what was not meant to be ruled out in original sources in the first place.
It is a meaningful research plan to develop conceptually consistent Shariah council benchmark suites. Such work can be done empirically by inspecting the jurisprudence as developed by an existing Shariah court, but it can also be done in a more intellectual fashion on the basis of interviews with Islamic scholars.
[BM2010] J.A. Bergstra, and C.A. Middelburg, source paper on RPSF posted on http://arxiv.org/abs/1012.4291
[BM2011a] is the previous item in this blog
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