Title: Towards an Interest Free Islamic Economics System
Author: Dr. Waqar Masood Khan
Publisher: The Islamic Foundation, UK, 1985
The book is authored by Dr. Waqar Masood Khan and it is based on his PhD Thesis completed and accepted with distinction at Boston University. The noted author has been a prolific academic researcher and policymaker. Currently, he is Advisor to the Prime Minister of Pakistan on Revenue. He has also served as Finance Secretary in the past. This book published in the mid-80s presents the optimism and ideas of foundational scholars in institutionalizing Islamic finance in contemporary economies.
It is one of the rare works in Islamic economics that engages in mathematical modelling. Since interest based financing is prohibited in Islam, the author attempts to make a case for equity financing and to use incentive features that minimize the cost of monitoring and information collection which make equity financing less attractive to the investor of capital as compared to the fixed rate scheme of lending.
Based on the results of a mathematical model, the author shows that the predominant role played by the interest based transactions or debt in modern credit markets can be explained by the presence of a ‘moral hazard’ in these markets. Given the presence of informational asymmetry in the credit market, interest-based financial instruments minimize the informational requirement of a financial contract. Since information collection is costly, interest-based contracts are attractive on account of minimizing the information costs associated with any contract.
On the savings supply side, if savings are unrelated to a positive rate of profit or mark-up in a narrow band of positive values, it does not imply that they will be inelastic to even negative profit rates. Thus, for risk averse and loss averse investors, fixed rate schemes still have attraction with safety of capital. Furthermore, as compared to macro level studies, the micro level surveys do hint towards positive relation between savings and profit rates.
The author highlights through the result of mathematical modelling that if the lender extends large number of smallest possible loans, then he can reduce the probability of default from any one investor to an arbitrary small level. In the presence of a large number of investors, if one investor defaults, then its effect on the lender’s expected payoff is negligible.
Can this minimization of risk through portfolio diversification also make equity financing usable and attractive. Equity financing may not guarantee returns and there is a possibility of negative returns; however, a diversified portfolio of small equity investments in large number of uncorrelated projects can minimize the risk.
On the upside, the presence of equity premium in the financial markets presents an opportunity of greater returns in equity investments. There are risk neutral investors who would be willing to engage in high risk-high return investments. The author gives an example that the very existence of the stock market reflects society’s desire to build up institutions for shifting risk to those most suited for this purpose, namely the stockholders.
The author notes that for risk averse investors, banks minimize moral hazard problem through monitoring. If there are monitoring costs associated with financial contracts, then debt minimizes these costs. The prohibition of debt as an instrument of financing would require investment in costly information collection activities.
Furthermore, portfolio diversity would be inhibited by firm-specific information collection costs. A diversified portfolio might help in reducing overall risk, but it will require collecting peculiar and firm-specific information.
There may be cost synergies in collecting information for minimizing systematic risk. But, such synergies are not available in collecting all sorts of information to minimize unsystematic risk. In addition to that, mutual funds investing in equity instruments also fail at times and remain unable to eliminate the systematic risks.
It also needs to be appreciated that the flexibility in entry and exit in financial investments is also a vital feature in determining the extent of use of a financing mechanism in a given situation. Proliferation of debt based instruments priced at fixed rate is based on the fact that the return is not uncertain. It is usable for different maturities from overnight loans to perpetual debt.
Therefore, the author admits that it is difficult to believe that the present system, though un-Islamic, is entirely without merit inasmuch as it satisfies the needs of those actively envisaged in it. Knowledge of its merits would help evolve a system that would take into account these merits and assimilate them into an Islamic framework.
The presence of debt, for example, in the capital structure of a firm, provides incentive for better management relative to the case where the managers sell the ownership to the outsiders, as in the case of equity.
Therefore, if the financial institutions are incapable of controlling the effort level of the manager/agent, then the introduction of profit sharing will greatly reduce the performance and efficiency of the business enterprise.
Nonetheless, if banks hold equity, then they can still perform the effective monitoring as compared to the large number of small shareholders. But, since the underreporting of profits is possible and there is information asymmetry, there will be increased information collection and monitoring costs in equity financing.
In short term financing where the period of investment is shorter and the published financial statements are not available for a shorter frequency than a quarter, the author is in favour of profit calculation based on expected and forecasted values and such can be adjusted when the actual data is available.
The author cites the example of income taxation. Certain taxes are deducted at source and adjustable at the end of period if documentary evidences are presented. However, the author notes that while taxation authorities have the power to scrutinize the accounts, in private contracts where an easy tax-favourable debt financing is available, firms would not be willing to share their private information wholeheartedly.
The author notes that the collateral requirement makes the access to credit exclusive to the rich capitalists who already own sufficient amount of wealth and valuable assets. Hence, equity financing is more inclusive and egalitarian from the social and distributional point of view.
The author writes that dishonesty is a function of the incentive structures afforded by the society. Costs can be minimized by devising incentive structures that ensure honesty of agents by themselves.
The requirement of collateral can be replaced with other features in the contract, such as equity at default. The author maintains that if there is asymmetry in management, then there can be asymmetry in sharing actual profits provided that profit distribution is not predetermined and fixed. Thus, tier based profit sharing is also a possible way of influencing incentives and ensuring risk mitigation.
In pricing capital in Islamic credit contracts, the author suggests looking at average profit rate of the industry or the economic growth rate.
Nonetheless, it is important that such rates do not determine the final distribution of profits and that the financing arrangement is structured on equity basis rather than debt. The eventual distribution of profits shall be adjusted based on actual profits earned once such calculation is possible at maturity.