Some methodological aspects of comparative financial paradigm research

Jan Aldert Bergstra & Kees Middelburg

In our recent paper [BM2010] on Reduced Product Set Finance (RPSF, Twitter hashtag #rpsfi), we have outlined a plan for technical research on the foundations of interest prohibition. Interest prohibition has a very long history and is nowadays strongly advocated by proponents of Islamic finance. In [BM2010] we have coined RPSF as a container concept which includes Islamic finance and variations thereof. In doing so RSPF can be positioned as a subtheory of conventional finance and by inheritance (the theory of) Islamic finance becomes a subtheory of conventional finance. For setting up technical work on specific issues, which is the objective of [BM2010], this viewpoint is satisfactory, but for motivating work on disparate financial systems it may not suffice.

Here we discuss the question how to understand the ideological basis of work on Islamic finance as seen from a Northern EU country and performed by researchers who have not been exposed to Islam in any systematic fashion. The discussion has several parts:

a) We consider the naming of financial systems at large first. This is a matter of terminology. Many papers make mention of the contrast between Islamic finance and other ways of organizing financial systems. Different indications for 'other finance' are used, for instance conventional finance. The contrast between Islamic Finance and conventional finance (also referred to as mainstream finance and sometimes as western finance) is problematic and places Islamic Finance in an exotic position which is a disadvantage for its students and proponents. Non-Islamic finance is an adequate name for mainstream finance, but its connotation is curious. Something better is needed, and we propose managed rational finance as an alternative. We must admit at once that 'rational' has potentially problematic connotations as well, but alternatives such as pragmatic finance, liberal finance or democratic finance are worse in that respect. We will use rational finance and acknowledge that rationality rather refers to the absence of certain exogenous influences than to the presence of a compelling design logic.

b) We discuss the unavoidable plurality of financial systems both in theory and in practice. We emphasize that neither Islamic Finance nor managed rational finance should be understood as monolithic and coherent financial paradigms. Both allow for diversity.

c) We discuss why limitations such as the prohibition of interest may be interesting for managed rational finance.

d) We argue why and how the investigation of RPSF and of Islamic finance might be useful from an EU perspective.

TERMINOLOGY. Rational finance versus World View Based Finance Rational finance (RF) refers to a financial system where all design decisions have been made on rational grounds. No other authority except
rational thinking from first principles is allowed in its conceptual construction. In particular old religious sources have no role in the design of RF. Managed rational finance (MRF) refers to a financial system which in principle has been based upon the results of rational thinking, but which also has been influenced by decisions made by governing bodies. A typical example of management influence on a financial system is the emergence of fractional reserve banking (FRB). FRB does not immediately follow from a principled analysis, but governing bodies may allow it when constrained by some regulation. Such regulations may be maintained (modified, redesigned) once circumstances change. A formidable spectrum of different ways to manage an RF system exists. Currently EU-MRF, USA-MRF and PRoC-MRF are not the same, though differences may seem small to non-specialist observers. Opposed to MRF, we see World View Based Finance (WVBF). A world view based finance need not be based on rational design decisions only. It can in addition make use of principles inherited from some world view, for instance a religion. Now Islamic Finance or more specifically each coherent approach to Islamic Finance might be considered an instance of a world view based system system of finance. One might criticize the proposed terminology because what is termed rational finance might also be called a WVBF with capitalism as the world view. Against this objection one may state that capitalism is just as well imaginable in a system of Islamic Finance and that the connection between rational finance and capitalism is a superficial one only. Clearly a WVBF must be managed just as well as an RF. Thus a multitude of MWVBF systems can be imagined, including variations of Islamic finance and per variation different approaches to its management.

In a system of rational finance, a financial product exists because some users like it. Only if the product's existence presents a risk to the system as a whole it will be ruled out by its managing bodies, often only after such risks have materialized in unacceptable ways. There are, however, limits to financial product development within rational finance that one hardly notices. For instance if we pack 10.000 Euro in  anknotes in a bag, which itself has a worth of 150 Euro, and sell that bag subsequently for 1000 Euro to a dear friend this is not a permissible spot sale in EU-MRF, because it constitutes a gift of 8850 Euro, which for that reason may involve a special form of taxation according to local (that is national) regulations. The classical and widely mentioned Islamic rule that gold may only be exchanged for equal amounts turns out to hold for Euros within Europe today.

PLURALITY. The viewpoint that Islamic finance is an exotic extremity peripheral to a monolithic and coherent mainstream financial system is erroneous. MRF's are all influenced by regulation and systems of regulation diverge. Today the EU-MRF has more faith in the validity of policies for keeping the amount of money in circulation limited than the USA government seems to have. Today's EU-MRF is less Keynesean than USA-MRF and that leads to different rules of behavior. Differences between regional RF's do not primarily reflect ideological positions, but rather they reflect differences in economic circumstances. Anyhow these differences may be enormous. Similarly it is implausible to view Islamic finance as one single coherent design. There are many conceivable variations on the theme of Islamic Finance, including theoretical versions that emerge from imposing grand simplifications. It should be noticed that Shariah compliance itself is not a universal concept. What is Shariah compliant needs to be found out time and again by local or regional scholars. One might even try to understand the universal prohibition of interest differently: whenever interest is paid, promised, received or expected it is possible (but not necessary) that a council of Islamic Scholars scrutinizing a specific event concludes that it was not Halal. The logic of Islamic finance is a matter that requires further investigation. Besides listing principles derived from various Islamic sources and traditions, one may consider the more dynamic aspect of Shariah Councils taking decisions in real time into account. It is not obvious from outside which considerations are taken into account when such decisions are taken.
That may range from an interpretation of pre-existing sources and traditions together with logical conflict resolution when these sources and traditions are or seem to be contradictory to the development of an expectation of the effect of some ruling which may be taken into account when deciding about that ruling.

RELEVANCE. Relevance of systems of world view based finance for approaches to rational finance. We focus in the prohibition of interest as a principle that is included in some systems of WVBF (in particular Islamic finance) and which is hardly visible in any MRF known at present. Consider EU-MRF. IT seems to be the case that the increasing spread in interest rates for government bonds for different EU countries creates problems of a magnitude that had not been foreseen when the Euro was created. Market forces create discrepancies that can be remedied only temporally by means of policies that cannot make use of the political union which some authors had always stated to be a precondition for a stable Eurozone. Some national citizens feel trapped in a EU that preaches an independence of states which is not sufficiently powerful to prevent monetary dissociation and at the same time preaches the virtues of an extending Eurozone.

One might guess that the UK's disinclination to join the Euro may be be connected to its dislike of further political unification within the EU in combination with an understanding of the market forces just mentioned. Increased interest rates constitute the main signal sent by these market forces. Another issue that makes interest free systems intriguing is that monetary policies tend to move interests towards zero in times of stagnation and when it matters most no further step can be taken because handling negative interest is a technical problem for the financial system at large. So it seems that, in order to have interest rate setting available as a weapon for managing the economy, it needs to be
significantly higher than zero 'naturally', just like a ship that needs speed for it to be controlled by its rudder. Now this is an asymmetric matter, in theory working with steady deflation might also work. Anyhow the double role of interest as a market price for credit and as a handle for managing the economy is not always comfortable.

In [Lewison1999] one finds other arguments against the free setting of interest rates, in
particular the fact that those in need of credit are likely to pay the highest interests because of the higher risk of default at the borrowers side. Lewison also explains that upper limits to interests asked by lenders and imposed by financial authorities may lead to adverse results because some potential borrowers may not be able to find any credit. One notices that interest rates reflect a mix of insurance against default and compensation for opportunity cost which might preferably be disentangled. From these considerations it may be concluded that principled investigations about the design of interest free WVBF's can be meaningful from the perspective of e.g. EU-MRF.

PERSPECTIVE. Potential gains from studying Islamic Finance from within the EU can be pointed out. It is conceivable that systematic work on RPSF, while taking the current EU-MRF into account, leads to the development of a viable EU-MWVBF based on principles of Islamic finance. This system, one might refer to it as an EU based managed Islamic finance (EU-MIF), may even become visible throughout the world, and instead of constituting a threat to the core EU identity it is an opportunity waiting to being exploited.

Reference: [BM2010], Preliminaries to an investigation of reduced product set finance. Available at http://arXiv.org/abs/1012.4291, submitted for publication to J. KAU. Islamic Economics.