Islamic Finance



Whilst economic activity is in part an effort to maintain or replace
old stocks of wealth that have depreciated, the making of an
accounting profit does not necessarily signify that such wealth
creating processes are occurring. For an example of this one need
look no further than a casino. Here, the winner of a game of
chance wins what the loser loses, less the casino's cut. As a result
of this cut, the gambling process is usually profitable for the casino
(which acts as an intermediary in the gambling process). Of
course, for the winners themselves, the process is always
profitable. However, in order to create new wealth, an economic
process must do more than simply transfer existing wealth
between participants.
The establishment of a national lottery can, from this point of view,
be seen as a misallocation of resources. If the state genuinely
wishes to raise extra revenue for charitable causes and the arts,
then the existing taxation system could in fact be used to raise the
required revenues at far lower cost. If the Inland Revenue already
exists, why bother setting up what is effectively a whole new
taxation infrastructure to duplicate it? In November 1994, soon
after the opening of the UK's national lottery, Joe Rogaly wrote in
the Financial Times :
The national lottery is fantasy finance. ... It is a tax on the poor
derided by the rich, a machine for the creation of a spurious sense
of self satisfaction for the pathetic boobies who toss their coins into
the maw. There is nothing of worth in this crap game, no net gain
for charities, no work of art saved or building erected that could not
have been financed by less preposterous means ... Games of
chance, according to the Koran, are abominations of Satan. "They
ask you about drinking and gambling," says the holy book. "Say;
'There is great harm in both, although they have some benefit for
men; but their harm is far greater than their benefit'." Drinkers may
demur, but, as to the lottery, the Islamic view is sheer common
The gambling process cannot unambiguously show that it provides
new wealth for the community, yet for the intermediary it is
profitable. If large numbers within a community attempt to survive
on a variety of wealth transfer processes, of which theft is one
further example, the implications for the maintenance of
infrastructure and social cohesion are almost entirely negative.
Human effort and physical resources, that could otherwise be
applied to creating new wealth, are instead diverted towards
activities that simply facilitate the transfer of existing wealth.
Some proponents of gambling argue that it produces pleasure to
those who win and is thereby creating a form of wealth. One need
only consider the fact that losing is highly unpleasurable in order to
see that, even in this sense, the amount of net wealth created in
the gambling process is close, if not equal, to zero.
Others argue in favour of gambling on the basis that all human
activity involves a kind of gamble. The argument proposed is that
to criticise gambling is to criticise any form of activity whose
outcome is uncertain. If the investment of money on a roulette
wheel is to be mocked, why not then the investment of money in a
new business? But when crops are planted the farmer risks
drought in order that we may have food to eat. I am yet to see in
what way a bet on red at the roulette wheel is capable of a similar
production of wealth. For an individual to say that 'planting crops is
a risk and gambling at the roulette wheel is a risk, therefore I might
just as well direct my effort towards roulette', is to ignore the fact
that farming is necessary to the maintenance of life whilst betting
on the roulette wheel is not.
The above argument is of great relevance to any debate on the
economic worth of financial market speculation. Some regard such
speculation simply as a form of gambling whose impact upon
resource allocation is similar to that of a casino. However, there is
at least one important difference. Financial market speculation can
affect a variety of economic variables such as exchange rates,
interest rates or commodity prices, whereas the placing of bets in a
casino cannot. Through its impact upon the price mechanism,
speculation can then have an effect upon resource allocation that
is far wider than its own domain.
Many proponents of speculation adhere to the view that there is
indeed a value-added process going on here. Three common
arguments are as follows.
Firstly, because of the volume of speculative transactions in the
major markets, let us use the market for foreign exchange as an
example, end-users requiring foreign currency will find a liquid
market in which to transact. Were no speculative operators to exist,
then an end-user might come to the market looking to exchange
one currency for another but find no counterparty willing to trade in
a reasonable size.
Secondly, the difference between the price at which the end-user
may sell or buy a foreign currency, the bid-offer spread, becomes
very narrow due to the competition between speculative
participants in the market. The tightness of this bid-offer spread
effectively reduces transaction costs.
Thirdly, as speculators trade out profitable opportunities, the
market price tends towards 'efficiency'. Whilst it is possible that
benefits are derived from liquidity and low transaction costs, the
chief beneficiary often seems to be the speculator himself. For this
agent, the need for speedy execution of trades in large size and at
short notice is paramount. Agents in the real economy place less
sanctity upon such features. The quip is that a consumer buys a
banana in order to eat it, not to sell it at a higher price later. More
seriously, one might ask whether is it quite so vital to the
functioning of the real economy that a foreign exchange deal
should take less than one minute to conclude. Would a viable
business project, that has taken several months to plan, be
cancelled because the necessary foreign currency trade can only
be completed at one week's notice?
The supposed improvement in price efficiency that is ascribed to
speculation is even more debatable. The level of efficiency in a
marketplace is commonly held to hinge upon the degree to which
available information is accounted for in current prices. Such a
definition seems to relegate the purpose of a marketplace to one of
secondary importance only. Can a market be efficient if it does not
allocate resources towards projects that maximise wealth creation?
Paul Volker, in an interview with the New York Times in the Autumn
of 1990, cites the destructive effects upon confidence and
business planning that foreign exchange volatility can cause. In
pinpointing speculation as the primary cause of such volatility, he
asks what possible argument of efficiency could justify an up move
of 30%, followed by a down move of 30%, in the $/Yen exchange
rate over the first few months of 1987. Are we to assume that
efficiency has nothing to do with stability in the market price?
In order to maximise turnover, financial intermediaries usually find
that volatility of some amount is quite desirable. It is less easy to
persuade a client to buy a dollar for one hundred yen if in all
likelihood the dollar will still be worth one hundred yen tomorrow.
Yes, it takes two to gamble, but should a financial institution
actually encourage the client to place his bets? Gestetner, Gibsons
Greetings, Metallgesellschaft and Orange County have all
experienced the skewed incentive system that so often awaits the
uninitiated. Little wealth creation here, but often a commission for
the bank's salesman. The Economist magazine of October 7th.
‘Red faces turned puce at Banker’s Trust, an American investment
bank in a legal battle with Procter & Gamble, a consumer goods
company. Leaked documents and tapes reveal that bank staff
talked about a "rip-off factor" attached to complex deals involving
derivative sales’.
Gordon Pepper in Money, Credit and Asset Prices (1994)
addresses the speculative psychology itself :
Market participants detect that following a trend tends to be a
profitable course of action. The herd instinct then prevails. Crowd
psychology becomes more important than the behaviour of
investors acting as rational individuals.. Technical analysis
(chartism), which is based on crowd psychology, becomes more
important than fundamental analysis.
Many homeowners in the United Kingdom now know how powerful
the herd instinct can be. This is especially the case where the
instinct is given substance by means of a substantial expansion in
money supply. Speculators may buy residential property because
the information available to them indicates that house prices are
rising. This may be efficiency in the sense of processing available
information, but it is often most inefficient in the sense of resource
allocation. When enacted by millions of households, the
speculative game can become a self-fulfilling money-spinner that
strips the price signal of any meaningful relationship to
fundamentals. Very quickly, pseudo-technical arguments of the '...
buy now while you can still afford it’ variety take over. In such an
environment, it is rarely asked whether the devotion of substantial
new resources to the construction of residential property meets a
genuine need for accommodation, or simply acts as a tool for the
making of speculative profit.
Pepper’s analysis may apply to the short-term only, but often the
short term is quite long enough for the market 'correction' to prove
highly destructive. The charity Shelter estimates that 100,000 low
cost permanent homes are needed each year to meet the high
levels of housing need in the UK. At the end of 1994, such
accommodation would have been welcomed by many among the
127,290 households that were homeless, the 419,890 that were
more than three months in arrears on their mortgages, and the
several million who were living under 'negative equity'. The frantic
construction boom of the 1980's did little for the affordable rental
sector but has instead bequeathed to us an array of un-lettable
office blocks and repossessed residential property that in some
cases sit side by side with the worst of housing shortages.
Whether it occurs in the financial markets or in the real economy,
the damage wrought by speculation seems far more obvious than
the supposed benefits proposed by its supporters. The efficiency
argument is dubious whilst the resulting resource misallocation and
economic destabilisationcan at times be most obvious.
Nevertheless, speculation, in spot foreign exchange for example,
seems quite acceptable among some Islamic institutions. Typically
I ask such participants whether they would bet their funds on a coin
toss. Invariably the answer is 'No'. But what exactly is the
difference between chancing money on a coin toss, and chancing
it on a currency rise or fall? 'In the foreign exchange market, one
uses one's mind, one examines information, one thinks' replied a
senior individual in an Islamic bank. 'Poker players do that too', I
Islamic financial institutions should be clear on at least one
principle. To profit by wealth transfer, or by wealth creation?