islamic finance conceptual and analytical issues from the perspective of conventional economics

7/30/2019 Islamic Finance Conceptual and Analytical Issues From the Perspective of Conventional Economics

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ISLAMICFINANCE:CONCEPTUALANDANALYTICALISSUESFROMTHEPERSPECTIVEOFCONVENTIONALECONOMICS

AndrewShengPresident,FungGlobalInstitute,HongKong

TheThirdHolderoftheTunIsmailAliChair,UniversityofMalaya

Email:[email protected]

and

AjitSingh

EmeritusProfessorofEconomics,UniversityofCambridge

LifeFellow,Queens College,CambridgeCB39ET,UK

TheFifthHolderoftheTunIsmailAliChair,UniversityofMalaya

Email:[email protected]

November2011

Pleasedonotquotewithouttheagreementoftheauthors.Commentsmostwelcome.

ThispaperwaspresentedattheTunIsmailAliChairinMonetaryandFinancialEconomicsPublic

Lectureon14thNovember2011,SasanaKijang,BankNegaraMalaysia


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TableofContents

I. IntroductionII. CentralTenetofIslamicFinance:AbsoluteProhibitionAgainstInterestRates

III. EthicalFoundationsofIslamicFinance

IV. ModiglianiandMillerTheorems

V. RiskSharing,RiskShiftingandCostsofBankruptcy

VI. TheRoleoftheIslamicStockMarket

VII.

Summaryof

the

Main

Findings

and

Conclusion

References

TableI: AComparisonbetweenIslamicandConventionalBanking


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Apart from the IMF, a number of nonIslamic financial centres have also taken

steps to encourage Islamicbankingand finance. Tax lawshavebeen revised to

facilitateSharihcompliantfinancialinstrumentssuchasthelongtermsukukbonds

mentionedabove. Anotablerecententrant in thisfieldhasbeenthenonIslamic

centreofSingapore,whichhasstarteddoingbusinessinIslamicfinance.Anumber

of

non

Islamic

countries

in

Europe

including

the

UK

have

also

taken

legal

action

to

facilitate Islamic banking as these countries want a slice of this fast growing

market. There are, however, also examples of jurisdictions that have passed

negativelegislation,usuallyonpoliticalgrounds,toprohibitthespreadofIslamic

finance. ThiscategoryofcountriesincludessurprisinglySouthKoreaandperhaps

notsosurprisinglysomeindividualstatesintheUS.

The reasons for expecting fast expansion of Islamic finance lie not only in the

increasing

incomes

of

Islamic

populations

but

also

in

the

fact

that

the

basic

infrastructureforIslamicfinancehasnowbeenlaidwiththeestablishmentofthe

AccountingandAuditingOrganizationforIslamicFinancialInstitutions(AOFFI),

and the Islamic accounting standards authority, the Islamic Financial Services

Board (IFSB), the international Islamic financial regulatory standardsetting

organisation. TheInstituteforEducation inIslamicFinance (ISRA)alsoprovides

an invaluable website that is increasingly the transparent source for Sharih

interpretationsonwhatisconsideredacceptableunderIslamiclaw(Sheng2011).

The Islamic Finance Global Stability Report, which wasjointly producedby a

number of organisations in 2010, presents a comprehensive overview of the global

financialarchitecture andthecooperationandcollaborationmechanismsamongIFSBmembers

needed topromoteacompetitive, resilient,and stable Islamic finance industry. The Islamic

FinancialStabilityForumthatresultedfromthisReport,andtheInternationalIslamicLiquidity

Management (IILM), provide Islamic finance with awider range of tools and instruments, as

wellasaroadmapleadingtowardavisionofanintegratedandsoundglobalIslamicfinancial

industry.(AhmedandKohli,2011.Pg.xxvii)

With theabove empiricalbackground we turn now to the main purpose of this

paperwhichistheoreticalandconceptual. ItseekstorelatetheconceptsofIslamic

finance to those of conventional finance and to examine certain important

economic questions which arise from the interactionsbetween the two kinds of

theories. The paper is written selfconsciously from the perspective of

conventionaleconomics. Itidentifiessimilaritiesanddissimilaritiesbetweenthese


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twosystemsofthoughtandspeculatesontheextenttowhichthedifferencescan

beresolved. Thecentralconclusionofthepaperisanoptimisticone,namely,that

eachof the twoparadigmsof thoughthas itsownstrengthsandweaknessesbut

canneverthelesscoexistwiththeotherwithoutanyseriousdifficulties.

Therestofthepaperisorganisedasfollows:Thefirstpart,sectionsIIandIIIwill

discuss the two fundamental tenets of Islamic finance, namely, (a) absolute

prohibitionofinterestpaymentsondebt,and(b)thefundamentalethicalbasisof

Islamic law. These will be examined from the perspective of conventional

economicstoreachtheconclusionthatalthoughsomeofthestricturesofmodern

economics against the Islamic paradigm are inaccurate others are still relevant.

Importantly, thispartof thepaperhighlights themoralhazards facedby Islamic

depositorsaswellasby theirbanks. Theanalysisof thesesectionswillhowever

indicate

that

these

moral

hazard

problems

apply

to

both

Islamic

and

non

Islamic

financeandthatavoidanceofmoralhazardwoulddependontheeffectivenessof

the disciplinarian function of bank risk management, financial regulation, the

bankruptcy courts and also the ethics of the key players in each system. Since

thesemayhavedifferences inpractice indifferent countries, it isnotpossible in

principletoarguethatonesystemismoreeffectiveinmoralhazardavoidancethan

theother.

From

the

two

basic

tenets

of

Islamic

economics

the

second

part

of

the

paper

will

go

on to consider in sections IV,VandVI the important relevant tenetsofmodern

economics: (a) the so called Modigliani and Miller (MM) theorems and their

implicationsforoptimalcapitalstructureofIslamicbanksandfirms,(b)theroleof

the concept of bankruptcy, its costs and who pays the main costs, and their

consequences for moral hazard for Islamic and nonIslamic finance and, (c) the

efficientmarketshypothesisandthetheoryofstockmarketswiththeirapplication

toIslamicinstitutions.Under(c)thepaperwillprovideacriticalbutconstructive

analysis of the concept of an Islamic stock market. A concluding section will

summarisethemainfindingsofthepaperandprovideabriefconclusion.

Toelaboratefurtherthepaperwillgivespecialattentiontothefollowingspecific

issues:

a. In view of the absolute prohibition in Islamic finance to pay any kind ofinterestondebt,animportantquestioniswhetherornotitispossibletorun


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efficientlyan economic systemwhichdoesnothaveakey role for interest

rates?

b. What roledo interest rates play in conventional economicsata theoreticalleveland inpracticalterms?Canothervariablessubstituteforinterestrates

inalternative

economic

systems?

c. Why and towhat degreeare the households, firmsandbanks involved inIslamic financevulnerable tomoralhazard?Theconceptofbankruptcy, its

costs for contracting parties under the two systems and their relationship

withmoralhazardwillbeanalysed.

d.Whatare the implicationsofMM theorems for Islamicbanksand firms? Isthereanoptimaldebtequityratiofortheseinstitutions?

e. What,ifany,shouldbetheroleofthestockmarketinIslamicfinance? Tobeacceptableforthelatter,howwouldtheIslamicstockmarketdifferfromthe

conventionalstockmarket?

Although this commentary on Islamic concepts isbased on modern economic

analysis,itfullyacknowledgesthecontributionsofthegreatcontemporaryIslamic

economicscholars,includingamongothers,ProfessorsAbbasMirakhor,Mohshin

Khan, Ahmed Ali Saddiqui and the eminent late IMF economist Dr. V.Sundararajan.Thispaperbuildsasmuchontheworkofthesescholarsasonthatof

conventionaleconomists.

II. CENTRAL TENET OF ISLAMIC FINANCE:ABSOLUTE PROHIBITIONAGAINST

INTERESTRATESInthe1970swhenthesubjectofIslamicfinancewasfirstraisedinaseriousway,its

centraltenetoftheabsoluteprohibitionofinterestpaymentsondebtwasseverely

criticisedbymainstreameconomists. Itwasalleged that suchaprohibitionwas

incompatible with modern economic analysis and would result in a gross mis

allocationofresources. Itwasdubbedasazerointerestsysteminwhichtherewas

noreturntocapital.ProfessorMirakhor(2009)reportsthat theBBCandtheWall

StreetJournal regarded the systemasbeing totallynonviableandderived fromvoodooeconomics.


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Apart from these popular criticisms of Islamic injunctions against any interest

payments,therewerealsoseriousacademicobjections.ProfessorMirakhor(2010)

summarisesbelowthemainpointsofthesecriticisms:

thatzero interestmeant infinitedemand for loanable fundsandzerosupply;

such a system wouldbe incapable of equilibrating demand for andsupplyofloanablefunds;

withzerointerestratetherewouldbenosavings; thismeantnoinvestmentandnogrowth; inthissystem,therecouldbenomonetarypolicysincenoinstruments

of

liquidity

management

could

exist

without

a

fixed

predetermined

rateofinterest;and,finally,

thisallmeantthatincountriesadoptingsuchasystemtherewouldbeonewaycapitalflight.

Itshouldbenotedthatalltheabovecriticismswouldalsoapplytocountriesthat

practiceZeroInterestRatePolicies(ZIRP)underquantitativeeasing.

Incontrast

with

Islamic

economic

analysis

conventional

economists

widely

use

the

notion of interest rates in their work. In terms of their paradigm they have

legitimate use of zero interest rates, negative interest rates as well as positive

interest rates in examining real world economies. To illustrate, about half a

century ago, a leading Marxist economist of the time, Maurice Dobb (1960)

suggestedthatfromthesocialpointofview,therateofinterest,connotingsocietys

time preference, shouldbe zero. Individuals die while society goes on forever.

Thereisnoreasontofavouronegenerationoveranother.

In a parallel contribution around the same time, Maurice Dobbs pupil A.K.Sen

(1962, later to win the Nobel Prize) argued that even though society goes on

forever, in a growing economy, there shouldbe time preference for the present

whenpeoplearenotsorichastheywouldbeatafuturedate. Thiswouldindicate

normallyspeakingarelativelylowpositiveinterestrate(asopposedtoazerorate).


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Thatwouldallowarelativelygreaterconsumptiontodayandarelativelysmaller

consumptiontomorrowthanwouldotherwisebethecase.

In conventional economics the negative interest rates often arise from the

governmentsindustrialpolicywherethegovernmentwishestoencouragecertain

industriesandisthereforewillingtosocialisetherisksinvolvedfortheindividual

firm;inotherwordsthegovernmentsubsidisestherelevantactivitiesofthefirm.

Highpositiveinterestratesalsohaveaplaceinconventionaleconomicsanditmay

be useful to elaborate on this work in view of its claimed relevance to many

developingcountries,particularlyduring theprocessof financial liberalisation in

thesecountriesintherecentdecades. Theobviousreferencehereistothehighly

influentialworkinthe1960s,and1970s,andsubsequentlyofthesocalledStanford

SchooleconomistsMcKinnon(1973)andShaw(1973). Inaseriesofpapers,written

independently, the two economists argued strongly in favour of financial de

repression. Theysuggested that the liberalisationof the financialsystemwould

lead to higher interest rates and thereby to greater savings, investments and

growth. This work is controversial and its conclusions are contrary to much

mainstream economics as well as those of Islamic finance. It will thereforebe

useful to examine more fully the main assumptions and conclusions of the

Stanfordschool.1

The Stanford economists advanced inter alia, the following main propositions

concerningtheroleofinterestratesinlongtermeconomicgrowth(McKinnonibid;

Shaw ibid; for a classic review of the early literature, see Fry 1988; see also Fry

1997). First,financialdeepeningthroughgrowingfinancial intermediationand

monetization of the economy aids economic development. Secondly, financial

repression, whereby in many third world countries the Governments hold the

interest rates artificially low and provide subsidized credits either to favoured

sectors or to themselves, is inimical to long term economic growth. Thirdly,

liberalization of these repressed credit markets will foster development, since

raisinginterestratestotheirequilibriumlevelsleadsnotonlytohighersavings

butalsotomoreefficientuseofinvestmentresources.

1SectionsIIandIVdrawonandupdatethematerialinSinghandHamid(1992)andSingh(1995). SeealsoSingh(1997).


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Alltheseassertions,particularlythe lasttwo,aredebateablebothatatheoretical

level as well as empirically. It is not our purpose here to provide a detailed

analysisofthesepropositions. Sufficetosay,verybriefly,thatinthemainstream,

the Keynesian economists in particular, contest the McKinnon and Shaw

hypotheses on the ground that their underlying model assumes that savings

determine

investment.

Since

saving

is

done

by

different

economic

agents

(individuals and households), and investment is doneby other groups such as

firms and entrepreneurs there is no reason why savings should determine

investment. CriticsalsopointoutthatMcKinnonandShawassumethereisalways

fullemploymentofresources. Moreover,theysuggestthatwhetherornothigher

interest rates in the formal sector following liberalizationwill increaseaggregate

savings depends on the savingsbehaviour of the losers and gainers from this

process. To the extent that the personal sector finances the investments of the

corporate sector, which in developing countries are often highly geared, higher

interest rates may reduce corporate profits and retained earnings. The central

pointisthat,althoughtheriseininterestrateswillincreasepersonalincomes,ifthe

savingspropensityofthepersonalsectorislowerthanthatofthecorporatesector

(whichislikely),itwillleadtoafallintotalsavings(Akyuz,1991).

More importantly, whether for the above reasons or others, empirical evidence

from many countries, particularly Asian countries, which liberalized their credit

marketsin

the

1980s

and

1990s

and

increased

real

interest

rates

did

not

indicate

a

systematicrise inaggregatesavings. AsChoandKhatkhate(1989)notedintheir

influentialanalysisofthefinancialliberalizationexperienceoffiveAsiancountries

(Indonesia,Malaysia,Philippines,RepublicofKoreaandSriLanka):

Itwasbelievedthattheremovaloftherepressivepolicieswouldboostsaving. Thesurveyinthis paper of the consequencesof reformsdoes not reveal any systematic trend or pattern in

regard tosaving (andalso investment), though itclearlydemonstrates that reformhasgreatly

contributedto thefinancializationofsavings. Inmostofthesecountries,savingschanged ina

randomfashion.

Akyuz (1991) reached the same conclusion with respect to aggregate savings in

relation to Turkeys liberalization experiment during the late 1970s and in the

1980s.

Asfortheeffectsofcreditmarketliberalizationontheefficiencyoftheinvestment

allocationprocess,leavingasidethedisastrousconsequencesofsuchliberalization


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intheSouthernConecountriesinthe1970s,manysuccessfuleconomieshaveused

subsidiesindeednegativeinterestratesforlongperiodsoftimeasanimportant

partoftheirindustrialpoliciesduringthecourseofeconomicdevelopment. This

hascertainlybeentrueofJapan,whichprovidednegativerealinterestratestoits

favoured corporations for much of the postwar period of its most rapid

industrialization

(1950

to

1973).

Thus

Sachs

(1985)

notes

in

relation

to

Japan:

Domestic capital markets were highly regulated and completely shut off from world capital

markets. The government was the only sector with access to internationalborrowing and

lending. Foreign direct investment was heavily circumscribed, with majority ownershipby

foreignfirmsboth legallyandadministrativelybarred. Duringtheearly tomid1950s,abouta

thirdofexternalfundsfor industrial investmentoriginated in loansfromgovernment financial

institutions,atpreferential rates thatvaried across firms and industries. These state financial

institutionsremainedanimportantsourceofcheapfinancinguntilthe1960s.

AsAmsden (1990)pointedout, subsidiesanddirected creditwerealsoa central

feature of the Republic of Koreas highly successful industrial policy during the

previoustwodecades.

To sum up there is enough evidence to indicate that, contrary to the Stanford

school,ahighinterestratepolicybasedonfinancialderepressionwasapparently

notregardedasbeingsuitablebymanydevelopingcountries. Themostsuccessful

economiesinEastAsiadidnotfollowsuchpolicies. Policymakersindeveloping

countries ordinarily try to maintain low interest rates in order to encourage

investmentandgrowth. Inthatsense,thereisunlikelytobemuchdifferenceata

practicallevel intheperformanceofIslamicandnonIslamiccountriesinthereal

world. However,ataconceptuallevel,thedifferencebetweenthetwoparadigms

is huge. Islamic scholars do not find anyjustification for positive interest rates.

Nevertheless, the fundamental flaw in themainstream stricturesagainst thezero

interestratepolicyofIslamicfinancewasthatitfailedtotakeintoaccountthefact

that although the policy did not reward financial investment with interest

payments, profits on capital and enterprise were fully allowed, and indeed

encouraged.

An economic system where the capital is rewarded according to its earning

capacity could be entirely adequate for achieving sufficient savings and

investments for economic growth,and forallocating them efficiently. The main

propositionofIslamicfinanceisthatthereturntocapitalisdeterminedexpostand


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would be based on the return to economic activity in which the capital was

employed. Savingsand investmentwouldbedeterminedby thisexpost rateof

returnoncapital.Indeed,subsequentresearchshowedthattheIslamicsystemcan

bebasedentirelyonequitycapital,withoutdebt,andisthereforeoftenmorestable

than the conventional systembased on debt. This question willbe discussed

further

in

section

IV

where

the

Modigliani

and

Miller

theorems

and

their

implicationsforoptimalfinancialstructureforfirmswillbeanalysed.

Thisdiscussionraisesanimportantquestionforconventionaleconomists,whether

aneconomicsystemrequiresanexanteinterestratetofunctionefficiently. Here,

ProfessorMirakhor(2011)hasremindedusthattheArrowDebreuHahnsystemof

generalequilibrium,togetherwithitswelfarepropertiesdoesnothaveanexante

interest rate in the analysis. This system is totally viable and is indeed the

crowning

glory

of

modern

economics.

Adding

an

extra

variable

such

as

the

interestratewouldoverdeterminethesystemandwillbedifficulttointerpret.See

alsoMilgate(forthcoming).

Itisalsointerestingtonotethatbecausethereiscompetitionbetweenconventional

investorsandinvestorsinIslamicbanksthereisnotlikelytobemuchdifferencein

theratesofreturn(interestinthecaseofconventionalbanksandshareofprofitsin

thecaseofretailIslamicprofitandlosssharing(PLS)accounts)earnedbythetwo

groups.

This

hypothesis

is

confirmed

by

a

recent

IMF

study

which

compares

the

rateofreturnfrom thetwokindsofbanking institutions inMalaysiaandTurkey

overtheperiodJanuary1997toAugust2010(seeCevikandCharap2011).

Thedatarevealed,asexpected,ahighdegreeofcorrelationbetweenconventional

depositratesandtherateofreturnonretailPLSaccountsinMalaysiaandTurkey.

Between January 1997 and August 2010, a correlation of one year term

conventionalbankdepositratesandarateofreturnforPLSaccountswas91per

centforMalaysiaand92percentforTurkey. Theeconometricresultsshowstrong

evidence of cointegration between conventional bank deposit rates and PLS

returns over the long term. Granger causality is found between conventional

deposit rates and the rate of return on PLS accounts both in levels and first

differences. AnimportantresultbasedonpairwiseGrangercausalitytestsindicate

thatthenullhypothesisthatchangesinPLSreturnsdonotGrangercausechanges

inconventionaldepositratesbothinMalaysiaandTurkeycannotberejected,but

the null hypothesis that changes in conventional deposit rates do not Granger


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causechangesinPLSreturnscanberejected. Theauthorsalsouseerrorcorrection

methodologyandfindthatcausalitytestsconfirmthefindingsbasedonpairwise

Grangercausalitytests(CevikandCherap,2011).

Thus,inbroadtermsanIslamicbankingsystemisanessentiallyequitybased

systeminwhichdepositorsaretreatedasiftheyareshareholdersofthebank.

Thereisthusnofixedpaymenttothedepositorsfortheirmoneybuttheyare

entitledtoashareoftheprofitsofthebank.

Inthisequitybasedsystem,corporategovernanceisratherdifferentthanintheconventionalsystem. Itwillbearguedbelowthatthisleadstoproblems

ofmoralhazardfortheIslamicbank.

ItwillbesuggestedfurtherthattheredistributivestanceofIslamiclawsleadstotheproblemsofmoralhazardforthedepositor.

Thisrequireseitherstrongethicsorverystrongregulation,orbothfortheresolutionofthesedifficulties.

Inviewof theirsignificance for the theoryandempiricsof IslamicFinance these

pointswillbeexaminedmorefullyinthenextsection.

III. ETHICALFOUNDATIONSOFISLAMICFINANCEAlthough the rejection of interest payments is an essential element of Islamic

finance,thefoundationsofthelatterlieincertainethicalprincipleswhichinturn

emanate fromQuranSunnah and legal and ethical reasoningofSharih scholars.

These in theirentirety constitute thebasis for Islamic finance. Ethicalprinciples

guiding Islamic finance include significantly: the avoidance of Gharar: The concept

applies to preventable ambiguity and uncertainty, Ahmed and Kohli (2011, p).

Principles of Islamic finance are implemented through contracts. Sharih law

coversconditions

of

contract

and

inter

alia

rights

and

freedoms

of

the

contracting

parties.

ImportantlythereisastrongredistributiveelementinIslamicfinance.AsProfessor

Mirakhornotes in the conventional system,rich help thepoor as ademonstration of

sympathy,beneficence,benevolenceandcharity. In Islam,themoreablearerequiredtoshare

the consequences of the materialization of idiosyncratic risks illness,bankruptcy, disability,

accidents and socioeconomic disadvantaged for those who are unable to provide for


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themselves. The economically well off are commanded to share risks of those who are

economicallyunabletousethe instrumentsofIslamicfinance.In Islamicfinance,therisksthat

would face the future generations are sharedby the present generation through the rules of

inheritance. Theserulesbreakup theaccumulatedwealthas itpasses fromonegeneration to

anothertoenablesharingrisksofalargernumberofpeople,Mirakhor(2011,p15).

ToillustratewithasimpleexamplefromanelementoftheIslamicbankingcode,

consider the case of a mortgagee with an Islamicbank. In Islamic finance the

normal mortgage contract carries an implicit and explicit assurance that if the

mortgageeisunabletopayhismortgage,thecontractwillentitlehimforhelpfrom

theBank.

Some economists argue that this will create a moral hazard for the mortgagee.

However,opinionsdiffer. Otherscholarssuggest that if themortgageedoesnot

obey the Islamic ethical code outlined above he or she willbe subject to severe

sanctionsfrommembersof thecommunity. SimilarlyKhanandMirakhor(1993)

arguethattheBankshavedirectandindirectcontrolovertheagententrepreneurs

throughbothexplicitandimplicitcontracts. Thisisthecasebecausebankscould

refuse furthercreditorblacklist theagententrepreneurandputat stakehis/her

credibility and respectability. Thisbrings in a strong deterrent to irresponsible

behaviour. However Sundararajan (2011) observes that this argument does not

changethefactthatthebankhasnolegalmeanstointerveneinthemanagementof

thecurrententerprisewhileitisdonebytheagententrepreneur.

To the mainstream economist, it seems very unlikely that adherents of Islamic

finance will be able to live up to such high moral standards. Conventional

economics invariably assumes that humanbeings are selfish and analyses their

activitieson thebasisof thatpostulate. If the sameassumptionof selfishness is

madeinrelationtotheparticipantsinIslamicfinanceitwillleadtoahugemoral

hazardproblemonthesideofthedebtor.

ThereissimilarlypossibilityofmoralhazardonthesideoftheBank. Thisarises

fromtheunrestrictedMudarabacontractwherethebankmanagesthedepositsatits

owndiscretion. This increases themoralhazard forabankas itmay indulge in

more risk taking, without adequate capital. As Sundararajan (2011) notes,

investment depositors in Islamic Banks do not enjoy the same rights as equity

investorsinconventionalinvestmentcompaniesbutdosharethesamerisks.


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For these reasons, Islamic finance poses considerable pressure on the Islamic

Financemanagementtomanagetheir investmentriskstoavoidmoralhazard. It

alsoposesconsiderablepressureonthefinancialregulatorstomonitorinvestment

andagency(bankintermediary)behaviourtoavoidpassingallrisksultimatelyto

thedepositor. A thirdunknown factor is thecertaintyof the shariahbankruptcy

courts

to

enforce

disputes

over

contracts

that

show

clear

signs

of

moral

hazard

(or

shirkingbyborrower/investeetoavoidhisrepayments).

Table 1 in theappendix outlines the main differencesbetween Islamic and non

Islamicbanks.Themostrecentempiricalresearchby theWorldBankeconomists

shows that conventional and Islamic banking are more alike than previously

thought. Differences inbusiness models if they exist at all do not show in standard

indicatorsbasedonfinancialstatementsinformation. Otherdifferences,suchascostefficiency,

seem tobe driven moreby country rather thanbybank type differences. Finally, the good

performanceofIslamicbanksduringtherecentcrisisappearstobedrivenbyhigherprecaution

in liquidityholdings an capitalization,butno inherentdifference inassetqualitybetween the

twobanktypes,Beck,Kunt&Merrouche(2010). Althoughbasedonratherdifferent

data and a different definition of the analytical problem, the World Bank

economistsconclusionsfromtheirempiricalstudysupporttheconclusionsofthe

IMFeconomists,CevikandCherap,asdiscussedintheprevioussection.

AlthoughasnotedinsectionI,Islamicfinancehasexpandedveryfast,itstillhasa

small share of world finance and is still in a niche market Tan (2009). Somerespected commentators argue that the market has concentrated on the

developmentof safe, shortterm financial instrumentsand ignored the longterm

market. It is fearedby these scholars thatbecauseofpathdependencywhich is

characterisedbymanyeconomicevents, the Islamic finance industrymaysimply

continuetooperateontheshortendofthemarket. Indeed,thesewellwishersof

Islamic finance would like to takeamajor step forward and developan Islamic

stockmarket formeeting theneedsof the Islamic investors for investmentswith

longtermhorizons. Thisimportantquestionwillbeexaminedindetailinsection

V.

IV. MODIGLIANIANDMILLERTHEOREMSHavingexaminedthetwobasictenetsofIslamicfinanceweshallnowmoveonin

thesecondpartofthepapertoconsiderafundamentaltenetofmoderneconomics,

namely the so called Modigliani and Miller (MM) Theorems concerning the


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15

optimal financial structure of firms. We shall also analyse the feasibility and

desirabilityofestablishing stockmarketson Islamic rules toassist thegrowthof

Islamicfinance.

Sincethelate1950sanduntilrecently,themodernneoclassicalviewoffinancehas

beendominatedbythesocalledirrelevancetheoremsassociatedwithModigliani

and Miller (1958, 1961). In seminal contributions, starting with their pioneering

1958paper,ModiglianiandMillerputforwardtwocentralpropositionsaboutthe

theory of finance. They showed that in fully developed capital markets, under

fully idealised neoclassical assumptions of perfect competition, no transaction

costs,no taxation andnobankruptcy, even inaworldofuncertainty, the stock

marketvaluationof the firm is independentof its financingordividendpayout

decisions. On the basis of certain further restrictive assumptions about

expectations

and

the

nature

of

uncertainty

(e.g.

uniformity

in

expectations

held

by

allinvestorsonthestockmarket),itwasestablishedthatthemarketwouldvalue

thefirmssharesentirelyonthebasisofitsearningsprospects;sharepriceswould

beinvarianttothecapitalstructureofthefirmortotheextenttowhichitresortsto

internalorexternalsourcestofinanceitsinvestmentplans.

Miller(1991)providesanintuitiveexplanationfortheMMtheoremswiththehelp

ofananalogy.Thinkofthefirmasagigantictubofwholemilk.Thefarmercansellthewhole

milkasitis.Orhecanseparateoutthecream,andsellitataconsiderablyhigherpricethanthe

wholemilkwouldbring.TheModiglianiMillerpropositionsays that if therewerenocostsof

separation,(and,ofcourse,nogovernmentdairysupportprogramme),thecreamplustheskim

milkwouldbring the samepriceas thewholemilk. Vallimil furtherelaborateson this

explanationinthefollowingterms:theessenceoftheargument isthat increasingthe

amountofdebt(cream)lowersthevalueofoutstandingequity(skimmilk)sellingofsafecash

flowstodebtholdersleavesthefirmwithmorelowervaluedequity,keepingthetotalvalueon

thefirmunchanged.Putdifferently,anygainfromusingmoreofwhatmightseemtobecheaper

debt is offsetby the higher cost of now riskier equity. Hence, given a fixed amount of total

capital, the allocation of capitalbetween debt and equity is irrelevantbecause the weighted

averageof the twocostsofcapital to the firm is the same forallpossiblecombinationsof the

two.

At a deeper level, the Modigliani and Miller theorems suggested a dichotomy

betweenfinanceandtherealeconomy:corporategrowthandinvestmentdecisions

were dictated completelyby real variables such as productivity, demand for

output,technicalprogressandrelativefactorpricesofcapitalandlabour. Finance


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16

in this paradigm is always permissive and simply facilitates the investment

process.

Asinthecaseofneoclassicaleconomics,thenormalKeynesianperspectiveonthe

roleof finance in investmentandeconomicgrowthalsoassumeswelldeveloped

capital markets. However, this perspective does not postulate perfect capital

markets in the sense that the relevant informationon costs, reliabilityandother

aspectsofthetransaction,isnotavailableonequaltermstoalltheparticipantsin

themarket. AccordingtotheKeynesianview,corporateinvestmentisessentially

determinedbyanimalspirits,bybusinessmensconfidence,byexpecteddemand

andby the cost of capital. The latter variable in practice is regarded asbeing

relativelyinsignificantcomparedwithdemandfactors.

As they do not accept the assumption of perfect capital markets, Keynesian

economistsdo not generallybelieve that the Modigliani and Millerpropositions

areoperationalintherealworld. Theseneoclassicalirrelevancetheoremsalsorun

contrary to the traditional conception of a firms investment and financing

decisions. The traditionalviewwas a socalled peckingorder theoryof finance

(Donaldson, 1961; Myers, 1984 and 1985; Fazzari, Hubbard and Peterson, 1988),

which suggested that firms always preferred internal to external finance and, if

theyhadtouseexternalfinance,theywouldprefertoemploydebtand onlyasa

last

resort,

equity

finance.

The

firms

capital

structure

and

its

dividend

pay

out

decisions, in this analysis, were important variables which had an independent

influenceonitsshareprice. Moregenerally,thenonavailabilityoftheappropriate

kind of finance could constrain a firms growth or investment plans: this

suggestion was often incorporated in the postwar microeconomic investment

models in theKeynesian spirit. MayerandKuh (1957)andMayerandGlauber

(1964)areclassicreferences.TheseissueshavebeencarefullyexaminedinStiglitz

(1998and2005).

Paradoxically, the above traditional theory of finance hasbeen resurrected and

revalidatedbyanumberoftheoreticaldevelopmentsinthelasttwodecadeswhich

attempttorelaxsomeofthehighlyrestrictiveassumptionsoftheModiglianiand

Millerpropositions. With respect to the latter, itwasnotedat thesimplest level

thatiftaxationandpossibilityofbankruptcyandfinancialdistressareintroduced

intotheanalysis,thiswouldproduceanoptimalcapitalstructureforthefirmand

thus invalidate the ModiglianiMiller irrelevance theorems. Many corporate tax


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17

systems, for example, allow interest tobe deducted as costs, which provides a

significanttaxadvantageintheuseofdebtfinance. Thereis,however,atradeoff,

sincetoohighalevelofdebtincreasestherisksofbankruptcyorfinancialdistress

inaneconomicdownturn. Thissimpletradeoffmodel leadstoanoptimaldebt

equityratioforthefirm,whichmaximizesitsstockmarketvaluation.

Morecomplexconsiderationsandtheoreticaldevelopmentsinvolvingasymmetric

informationbetweeninsiders(managers)andoutsiders(creditorsorshareholders),

problems of adverse selection, moral hazard, agency costs, signalling and

transactioncostsleadtodifferentcostsofthevariousformsoffinanceandcanbe

shown tobebroadly compatible with the pecking order type theory outlined

above (Theclassicreferencehere isMyersandMajluf,1984). Ingeneral, this far

richer and more complete analysisof the issuespoints to the significanceof the

corporate

capital

structures

and

the

financial

decisions

for

the

real

economy.

At

theveryleast,thenewmodelsofthefirmsuggestthatfinanceisnotsimplyaveil,

but that therearevery important interactionsbetweencorporate financeand the

realeconomy. Thus,unliketheneoclassicalinvestmentmodels(seeinparticular

the widely acknowledged and valued contributions by Jorgensen and his

colleagues) which dominated the profession in the 1960s and 1970s, many

economistssubsequently in the lightof thenew interpretationofMMTheorems,

particularly the postKeynesian ones, came to regard cashflow and corporate

retainedearningsasbeingasignificantconstraintonafirmsinvestmentdecisions.

Howeverourmainconcerninthispaperisnotsomuchwithcorporateinvestment

decisions,but with the question of the financial structures of Islamic and non

Islamic firms. Stiglitz (1988)hasobserved thatunderverygeneral conditions if

thereisnochanceofbankruptcythenfinancialpolicyhasnoeffectonthevalueof

thefirm;thereisnooptimaldebtequityratio. Thissuggeststhatundertheneo

classicalassumptionsofMMTheorems,anyfinancialstructureforIslamicfirmsis

optimal, including that of all equity and no debt. However, if these strict

assumptionsarerelaxed,particularlywhenthereisarealpossibilityofbankruptcy,

thefirmvaluationwilldependonitsdebtequityratio. Thus,foranyspecificfirm

there willbe a corresponding optimal debtequity ratio. There is no reason to

believethatIslamicfirmswouldattempttoachieveorwouldhaveachievedtheir

respectiveoptimum financialstructures in termsofdebtequityratios. Does this

make Islamic firms less efficient? The answer is not necessarily sobecause the


18/35


19/35

19

Hence, there is essentially no differencebetween the nonIslamic finance lender

andIslamicequitycontractintheserespects. Theconventionallenderprotectshis

ownrisksandshifts thesebycontractingwith theborrower, to includecollateral

and guarantees. If however, the real interest rate rises, the DCF value of the

borrowersassetsdeclineandrealvalueofliabilitiesincreaseandhemaygo into

economic insolvency. At the same time, the collateral value of the lenders

holdingsof

collateral

also

declines,

(especially

if

they

are

land

or

equity).

Thus,

at

higher real rates of interest, especially during a crisis, theborrower moves into

economic insolvency and therefore (nontransparently) transfers the insolvency

risktothelendersandholdersofhispaper. Thisriskreversionisidenticalinform

forIFornonIFfirms.

There is a further cost ofbankruptcy (transactions cost in time, legal fees etc.)

whichtheborrowerorinvestormayhavetoinvestinsoastorecouptheirloanor

investment. Thus,ifbothIFandnonIFcontractsinvolveinvoluntaryrisksharing,

then theonlyrealdistinguishing featurebetween the twosystems iswhether the

bankruptcylawsarestrongenoughandefficientenoughforenforcement.

In the IF contract, there is a moral or nontemporal sanction on theborrower,

hoping that this soft power willbe more effective than hard power legalor

other means of enforcement to force theborrower to repay. The reason is that

there is information asymmetrybetween theborrowers true solvency and the

lender/investor. Theborrowermayengageinlyingorhidinghistruesolvencyin

orderto

pass

as

much

losses

as

possible

to

the

lender

and/or

investor.

We

cannot

judgeaprioriwhetherIFssoftpowerisnecessarilybetterthanthelegalpowerof

debtenforcement. Thisdependsonthecircumstancesofthecase,thelegalpowers

inacountry,andtheeffectivenessofthecourtsetc.

Toputitclearly,alldebtorrisksharingcontractssufferfrommoralhazard. Ifthey

arenotenforcedagainstcheatingorfreeriding,thenriskswillpasstothesolvency

holder/lender. Insimpleutilityterms,whenthemarginalbenefittotheborrower

ishigherthanthecostofsanctions,thenhewillnotpay. Animportantquestionis

therefore whether sanctions are real enough for the borrowers to make thenecessary adjustments so that if they cannot pay today, they shall at least pay

tomorrow.

Itisarguablethatthecostsofbankruptcytotheborrowersintermsofconventional

financearelowerfortheIFborrowerthanforthenonIFborrower. Inthecaseof

the latter therearenotonly the laws relating tobankruptcybutalsodaily court

judgementsimplementingthelaw. Thiswilltendtomaketheloancontractmore


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20

transparentandprobablymorepainful incaseofdefault. It isworthnoting that

thebasic lawsonbankruptcydiffergreatlybetweenadvancedcountries,notably

theUSandtheUK. InbroadtermstheUKlawislessuserfriendlytotheborrower

than the US law which has the Chapter 13 provisions for allowing the firm to

continueasagoingconcernforalongerperiodthanwouldnormallybepermitted

by

English

receivership

arrangements.

It

may

also

be

observed

that

because

of

the

novelty of Islamic finance there may be nonuniform implementation of the

bankruptcylawsforIslamicfirms. Itisnotclearhowmanycasesofbankruptcyin

Shariah law are ever settledby Shariah courts. It is also not clear whether the

judgementsofthesecourtsareacceptedmoregenerallybythepublicandbynon

Islamiccourts.

The conclusion of this section is that whether IF or nonIF is more effective in

avoiding

moral

hazard

would

depend

on

the

whole

financial

infrastructure

of

risk

management systems, regulatory systems and the court systems. If Islamic

Financial systems end up with lower debt/equity as a whole than nonIslamic

systems, then the IFsystem is likelytobeable tocushionshocksasawhole,but

thisisaquestionofpractice,notoneoftheory.

VI. THEROLEOFTHEISLAMICSTOCKMARKETIslamic economists greatly favour the establishment of a stock marketbased on

Islamicprinciples inorder to further theexpansionof Islamic finance. Longago

ProfessorMetwally(1984)observed:InanIslamiceconomywhereinterestbearingloans

areprohibitedandwheredirectparticipationinbusinessenterprise,withitsattendantrisksand

profit sharing, is encouraged, the existence of a wellfunctioning Stock Exchange is very

important.Itwouldallowforthemobilizationofsavingsforinvestmentandprovidemeansfor

liquidity to individual shareholders. However, existing Stock Exchanges in nonIslamic

economieshavemanydrawbacks. Theygeneratepracticessuchasspeculationandfluctuations

insharepriceswhicharenotrelatedtotheeconomicperformanceofenterprises. Thesepractices

areinconsistentwiththeteachingsofIslam.

Very recently, one of the foremost scholars of Islamic finance, Professor Abbas

Mirakhor(2011),hasarguedforgovernmentinterventiontodevelopavibrantand

activestockmarketinIslamicfinancecountries. This,hesuggests,canbejustified

on many grounds, but, importantly, empirical evidence has shown a strong and robust

relationshipbetween financial development, including an active stock market and economic


21/35

21

growth.Hegoesontoobservethat..arguably,thestockmarketisthefirstbestinstrument

ofrisksharing.Developinganactiveandefficientstockmarketcanpromoteinternationalaswell

asdomesticrisksharingwhichrendertheeconomyanditsfinancialsystemresilienttoshocks.

It is appropriate to start this analysis with a discussion of these issues in

conventionaleconomics. Theadvantagesanddisadvantagesofthestockmarkets

havelong

been

the

subject

of

acute

controversy

in

mainstream

economics.

In

the

first instance, we willbriefly review this debate and draw its implications for

Islamicfinance.

Inconventionaleconomics,JohnMaynardKeynes(1936)wasthe leadingcriticof

the stock market. He likened it to a gambling casino and warned that people

shouldnotbesurprisedbyunfavourableoutcomesiftheinvestmentdecisionsofa

nation are left to the vagaries of a casino. In contrast, like the Islamic scholars

above,the

mainstream

exponents

of

the

stock

market

believe

that

it

contributes

to

developmentthroughavarietyofchannels. Itcouldraisesavingsandinvestment

bymaking itpossible for individualsandhouseholds topurchasea fractionofa

shipyardorasteelmill,therebyspreadingtherisk,withoutwhichinvestmentmay

notoccuratall. Similarly themonitoring functionperformedautomaticallyand

fromtheperspectiveofanentrepreneur,costlessly,bythestockmarketalsohelps

raiseinvestment. Moreover,awellfunctioningstockmarketpurportedlyallocates

resourcesmoreefficientlythroughitsnormalpricingprocess,whichwouldaccord,

otherthingsbeingequal,highersharepricestoefficientfirmsandlowerpricesto

inefficientones.Furthermore,thetakeovermechanismostensiblyensuresthatnot

just thenew investment resourcesbutalso theexistingcapitalstock isefficiently

utilised. Inefficient use of existing resources is punished by the market for

corporate control through disciplinary takeovers.2 The other punishment is

throughbankruptcy and exit, which also carries with it the shame (sanction)

associatedwithbankruptcy.

How effectively the stock market can perform the above tasks depends on the

efficiencyofthreecriticalmarketmechanisms,namely(a)thepricingmechanisms

(b) the takeover mechanism and (c) the exit/bankruptcy mechanism. These are

central issues of debate on which there is a voluminous literature, which is

outlinedbelow.

2SeefurtherSingh(1992and2008)andtherelevantliteraturecitedinthesepublications.


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22

Theorthodoxparadigmof sharepricedeterminationpostulates that shareprices

areefficientbecause theyemanate fromperfectmarkets involving largenumbers

ofwellinformedbuyersandsellersinwhichnoonebuyerorsellercaninfluence

the price and where there is a homogeneous product, namely shares. There is,

however, an alternative paradigm indicatedby the passage from Keynes cited

earlier

that

characterizes

stock

markets

essentially

as

gambling

casinos

dominated

by speculators. Allenand Gale (2000);Shiller (2000); Shleifer (2000);Singh etal

(2005),BakerandWurgler(2007);HongandStein(2007)andnotleaststudentsof

behaviouralfinance[seeforexampleBarberisandThaler(2003);Hongetal(2007)

andBakeretal (2007)] formalize thevariouselementsof thisparadigm. Inbrief,

thisliteraturesuggeststhat,inthefaceofahighlyuncertainfuture,sharepricesare

likely tobe influencedby the socalled noisetraders, andby whims, fads and

contagion. For similar reasons of psychology, investors may attribute much

greater weight to nearterm price forecasts rather than historical longterm

performance. This lineofreasoning is taken further in thegrowing literatureon

behaviouralfinance.

Untilrecently,theempirical literatureonsharepriceshasbeendominatedbythe

socalledefficientmarketshypothesis(EMH),whicharguesthatrealworldshare

prices are efficient in the sense that they incorporate all available information

(Fama,1970).Inthe1980sand1990s,with(a)the1987USstockmarketcrash,(b)

themeltdown in theAsianstockmarkets in the1990sand (c) theburstingof the

technology stocksbubble in 2000, the EMH has suffered fundamental setbacks.

AlanGreenspan (1998)hascommentedas followson thereasons for (a)and (b):

At one point the economic system appears stable, the next itbehaves as though a dam has

reached abreaking point, and water (read confidence) evacuates the reservoir. The United

Statesexperienced suchasuddenchangewith thedecline instockpricesofmore than20per

cent on October 19, 1987. There is no credible scenario that can readily explain so abrupt a

change in the fundamentalsof longtermvaluationson thatoneday.Kindleberger (1989)

similarlydocumented about thirty casesof unwarranted euphoriaand excessive

pessimismon the stockmarkets since theSouthSeabubbleof1720. He termed

theseepisodesasmanias,panicsandcrashes.

JamesTobin (1984)madeananalyticallyusefuldistinctionbetween twokindsof

efficiencyofstockmarkets,(a)theinformationarbitrageefficiencythatensuresthat

all information concerning a firms shares immediately percolates to all stock


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23

marketparticipants,ensuringthatnoparticipantcanmakeaprofitonsuchpublic

information; (b) fundamentalvaluationefficiency, that is, sharepricesaccurately

reflect a firms fundamentals, namely the long term expected profitability. The

growing consensus view is that, in these terms, stock markets may atbestbe

regardedasbeing efficient in the senseof (a)but far frombeing efficient in the

economically

more

important

sense

(b).

Thus

EMH,

as

identified

in

(a),

is

compatiblewithsharepricesnotreflectingfundamentalvalues. Amoredetailed

discussionaswellasotherexamplesofsharepricesevidentlydepartingfromtheir

fundamentalsisprovidedinSinghetal(2005).

Apart from the normal mispricing, which is particularly likely tobe severe in

developingcountriesastheirfirmsdonothavealongtrackrecord,sharepricesin

developing countries are more volatile than in advanced countries [see further

Singh

(1997);

El

Erian

and

Kumar

(1995)].

Share

price

volatility

is

however

a

negativefeatureofstockmarketsforseveralreasons.First,itreducestheefficiency

of thepricesignals inallocating investmentresources. Secondly, it increases the

riskiness of investments and may discourage riskaverse corporations from

financing theirgrowthbyequity issuesand indeed from seekinga stockmarket

listingatall. Thirdly,at themacroeconomic level,ahighlyvolatilestockmarket

mayleadtofinancialfragilityforthewholeeconomy(Singh1997).

We

now

take

up

the

belief

of

Islamic

scholars

that

the

development

of

the

stock

marketwould lead to fastereconomicgrowthand fastergrowthofemployment

and consumption. This isavariantofwhatSingh (2008)has termed the World

Banksnaturalprogressionargument. TheWorldBankwhichnaturallysupports

theestablishmentof,andencouragementofstockmarkets throughout theworld,

basicallyarguesthatthestockmarketistheemblemofdevelopmentofacountry.

As a country develops, it tends to establish stock markets. Stock markets can,

therefore,be regarded as an insignia of economic development. Unfortunately,

economichistoryisnotcompatiblewiththisinterpretation.

Twokindsofevidenceare relevanthere. The first is theobservation thatof the

economicmiracleswhichhaveoccurredinthesecondhalfofthetwentiethcentury,

hardlyanycanbeascribedtostockmarketdevelopment. Thus,inpostWorldWar

IIEuropetheItalianmiracle(veryfastgrowth),theGermanmiracle,theAustrian

miracleandinAsia,thejustlyfamousmiraclesofKoreaorTaiwan,didnotdepend

conspicuously on the equity orbond markets in these countries. Similarly, the


24/35

24

secondkindofevidencerelevanthereconsistsofanexaminationofcomparative

growth rates over a longer one hundred years time span. Such an examination

reveals that thebankbased countries (for example Germany andJapan) have as

good if not abetter longterm record of economic growth than the US and UK.

Pagano(1993),notesthattheItalianstockmarketwasbiggerahundredyearsago,

than

it

was

in

1990.

The

Italian

economy

evidently

grew

during

these

hundred

yearswithoutanyexpansionofthestockmarket.3

It is important, in this context for Islamic scholars toalsobear in mind that the

stock market often spontaneously leads to the development of a market for

corporate control and this market is regardedby traditional economics as the

evolutionaryendpointofstockmarketdevelopment. Evidence,however,isallto

thecontrary. Researchshowsthatthetakeovermechanismasitworksinthereal

world

is

highly

flawed.

Selection

in

the

market

for

corporate

control

takes

place

noton thebasisofperformancealone,but,bothonperformanceaswellas size.

Thus,a large relativelyunprofitable firmhasagreaterchanceof survival thana

smallprofitablefirm. Thishasadverseconsequencesforeconomicefficiency.See

furtherTichy(2002),Scherer(2006),Singh(2008).Themarketforcorporatecontrol

insteadofbeingavehicleforeconomicefficiency,exacerbatestheshortcomingsof

stock marketby encouraging speculative takeovers of whole companies rather

than just buying and selling of few shares of individual companies. Thus, in

conventional economic terms, neither the pricing mechanism nor the takeover

mechanismintherealworld,arehelpfultoeconomicefficiencyanddevelopment.

Thethirdissueistheeffectivenessoftheexitmechanismforfailedcompanies,such

as delisting from the stock market or actual bankruptcy. The important

disciplinarianroleoftheexitmechanismisthatfailedinstitutionsshouldexitand

thatthereareconsequencesforfailure. Manyemergingmarketstockmarketsdo

not work well because of the lack of enforcement of rules or allowing more

delisting andbankruptcy of failed companies. Indeed, in a number of cases,

governmentshavebeenknowntointerveneinstockmarketstobailoutcompanies

introuble. Suchactiononlyengendersmoremoralhazardproblems,erodingthe

disciplinaryroleoffinancialmarkets.

3 Apart from thisbroadbrush evidenceon themeritsof the stockmarket for economicgrowth, therearealsoanumberofeconometricstudieswhichreportmixedresults.Thesestudiesareoftenbasedonreducedformequations

wheretheresultsaredifficulttointerpretintermsofcausation.SeeSingh(2008);Levine(1997).


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25

Fromtheexperienceofrealworldstockmarkets,itisdifficulttoseeapriorihow

such an institution would positively benefit Islamic finance, without stringent

supervisory,corporategovernanceandexitmechanismsinplace.

VII. SUMMARYOFTHEMAINFINDINGSANDCONCLUSIONAsthisessayhasrangedoverseveralfieldsofconventionalandIslamiceconomics,

it willbe useful to summarise the main theoretical and empirical findings. The

paperhasfirstexaminedthecentraltenetsofIslamicfinancefromtheperspective

of conventional economic analysis. It started with the question of absolute

prohibition of interest payments in any form under Islamic finance. The main

conclusion isthat it ispossibletorunanefficienteconomicsystemoftheIslamic

kind, which has no interest payments,but which allows profits on capital and

enterprise.Suchasystem,basedtotallyonequityfinanceiscompletelyviableand

may,infact,bemorestablethanapartdebtfinancedconventionalsystem.

Conventional economics legitimately uses interest rates zero, negative and

positiveratesforitsanalysisofrelevanteconomicconditions.Thereis,however,

little evidence to support the McKinnon and Shaw hypotheses that financial

liberalisationnecessarily leads tohigh interest rateswhich in turngeneratehigh

savings, investments and economic growth. The highly successful East Asian

countriesemployedlow,evennegative,ratesratherthanhighinterestratesduring

theirindustrialisation.

Asdeveloping country policy makersare prone to use lowbut positive interest

ratesinordertoencourageinvestmentandgrowththereis,inpracticalterms,very

littledifferencebetweenconventionalandIslamic(zerointerestrate)paradigmsin

theirpracticalapplications.Theratesofreturnondeposits inconventionalbanks

andthoseofprofitsharingaccountsinIslamicfinancetendtobehighlycorrelated

andbroadlyofsimilarmagnitude.

AnanalysisofthesecondmajortenetofIslamicfinance,namely,itsethicalsystem

indicates that ifhumanbeings strictlyadhere to the requirements of the Islamic

ethics therewouldbe fewmoralhazardproblems in Islamicbanking.However,

sincetotaladherencetotheIslamicethicalsystemisunlikelyformostindividuals,

importantmoralhazardissues,bothonthesideofthedepositorsinIslamicbanks


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26

aswellasonthesideoftheIslamicbankthemselvesloomlarge.Thesewouldneed

toberesolvedintherealworldbyextensiveregulation.Itisamootpointwhether

such far reaching regulation of individual ethicalbehaviour is at all feasible or

desirable.

Turning to the relevant chief tenetsof conventional economicswe first find that

there is no straight forward application of Modigliani and Miller theorems to

Islamic firms and banks. This is because the assumptions underlying these

theoremsofnotransactionscosts,perfectmarkets,notaxationandnobankruptcy,

depart considerably from the real world situations. If these assumptions are

relaxedtoconformmoretotherealworldthenonewouldgetanoptimalcapital

structure,i.e.someparticulardebtequityratioforaspecificfirm.However,thisis

optimalityfromthepointofviewofthefirmratherthanthepointofviewofthe

society

as

a

whole,

so

it

will

be

difficult

to

reach

the

judgement

that

Islamic

firms

havenonoptimalcapitalstructuresonthebasisofModiglianiandMillertheorems

alone.

Although for MM theorems, the concept ofbankruptcy is important, in the real

world, it is its costs and who pays these which are significant factors in

distinguishing between the two systems. The real issues are information

asymmetry, the principalagent (contract) and insolvency costs, and whether or

not,

the

operation

of

these

concepts

leads

to

a

hard

budget

or

a

soft

budget

constraint for theborrowing firms which do not wish to pay and to shift the

burdentothelender. IntheIslamicfinancecontractthereisanadditionalimplicit

sanctionagainst this typeofmoralhazardof theborrowerwhichmaybe called

softpower.Thismaybeinsomeinstancesmoreeffectivethanthehardpower

ofthebankruptcylawsbutitisdifficulttoimaginethatitwilldosoeverytimeor

inmostcases.

The paper considers the desirability of establishing stock markets to further the

completion of the Islamic finance programme and to help with its expansion. It

providescriticalbutconstructivecommentsonthisimportantproposal. Thepaper

suggeststhatbecauseitisimpossibletodistinguishbetweenspeculativeandnon

speculativeinvestmentstrategiesitwouldbedifficulttoestablishintherealworld

astockmarketwithIslamicethicsinwhichnonspeculativestrategiesarefollowed

byallplayers. Thepaperalsofoundthatitisnotcorrecttosaythathistoricallythe

stockmarkethasplayedakeyroleineconomicdevelopmenteitherintheperiodof


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27

fastgrowthof theworldeconomy since theSecondWorldWarorovera longer

periodcomprising the lasthundredyears. Incountries likeJapanandGermany,

banks rather than the stock market have played the pivotal role in economic

development.InthepostWorldWarIIperiod,theGermanmiracle(ie.historically

fastgrowth),theItalianmiracle,theAustrianmiracleandinEastAsiatheKorean,

the

Japanese

and

the

Taiwanese

miracles

were

not

conspicuously

aided

by

the

stockmarket. InGermany,untilabouttwodecadesagotherewereonly650firms

listed on the stock market of which only 25 were actively traded. Similarly, in

setting up their economic system after the Second World War, the Japanese

deliberately favoured the development of the mainbank system rather than the

stockmarket(Singh1995,2008). Thepaperdrawsattentiontootherdrawbacksof

thestockmarketsandtheassociatedmarketforcorporatecontrolwhichwillnotbe

helpfulforanIslamiceconomy.

In conclusion, a conventional stock market would not be useful for Islamic

economiesbutaShariahcompliantstockmarketwithoutspeculativeplayersmay

bedifficulttoorganise. Yet,thesearchforanethicalstockmarketmustcontinue.

To sum up and to conclude briefly, the two systems, the Islamic and the

conventionalhaveexisted sideby side for the last twoor threedecadeswithout

any serious conflict. The conventional system, if anything, has helped the

development

of

Islamic

finance.

As

Islamic

finance

becomes

stronger,

there

may

be room for conflictbut it is not inevitable. Cooperationbetween these two

systemsiseminentlydesirableandfeasible. TheconventionalandIslamicfinance

maycooperateorevencompetetoproducethebestoutcomeforcommonprojects

suchas theprovisionofcheapbanking for theworldspooror for investment in

environmentalundertakings. Thereareareasinwideningaccesstofinancewhich

may be more desirable under Islamic finance because of the ethical basis of

funding. It is arguable that conventional finance,because of its use of debt, is

likelytohaveafaster,butmoreunstable,growththanIslamicfinance. Thuseach

systemhasitsstrengthsandweaknessesandonecaneasilycoexistwiththeother

tothebenefitofhumankind.


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28

TableI:AComparisonbetweenIslamicandConventionalBanking

Source:IslamicFinance:WritingofV.Sundararajan,Eds.J.AhmedandH.S.Kohli,2011.

Features Islamicbanking Conventionalbanking

Guaranteeofthecapital

Valueof:

Demanddeposits

Investmentdeposits

Rateofreturnondeposits

Mechanismtoregulate

Finalreturnsondeposits

Profitlossprofit(PLS)

principleapplies

UseofIslamicmodesof

financing:

PLSandnonPLSmodes

Useofdiscretionby

bankswith

regardtocollateral

Yes

No

Uncertain,notguaranteed

forinvestmentdeposits.

demanddepositsare

neverremunerated.

Dependingonbank

performance/profitsfrom

investment.

Yes

Yes

Generallynotallowedto

reducecreditriskinPLS

modes.Bywayof

exception,maybeallowed

tolessenmoral

hazardin

PLS

modes.

AllowedinnonPLS

modes.

Yes

Yes

Certainand

guaranteed.

Irrespectiveofbank

performance/profits

frominvestment.

No

Notapplicable.

Yes,always


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29

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