Why did the Vatican suggest Islamic finance?by İsmail Özsoy*

February 14, 2013, Thursday/ 16:36:00

Just after the 2008 global financial crisis hit, the Vatican suggested using the Islamic finance and banking system as a solution. So then what does Islamic finance offer? To answer this question we had better first lend an ear to the saying of the Prophet Muhammad: “You should sell gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates, and salt for salt, like for like, equal for equal, and hand-to-hand; if the classes differ, then you may sell as you wish, provided that the exchange is hand-to-hand.”

With this concise saying, the Prophet Muhammad expresses exactly 80 kinds of exchanges, which are the exchange of a commodity for another commodity or a currency for another currency on credit or on the spot and for matching or different quantities. According to that Prophetic saying, out of these 80 kinds of exchanges, 46 sales bear a religiously forbidden “interest.” Interest is a value that is transferred from one party to another without a matching value given back. Interest is sometimes “unearned income” in a zero sum game and sometimes “unequally distributed income” in a positive sum game. Thus, interest is, in any case, a wrong done to one of the two parties in loans or exchanges. That is why it is condemned by all religions and criticized by most philosophers.

From the Islamic perspective, interest (interchangeable with riba or usury) is an actual or potential excess or surplus without a returning equivalent not only in loans -- whatever the interest rate is -- but also in the exchanges of commodities and currencies. There are two kinds of interest: (1) Interest on debt or loan, (2) Interest on exchange transactions. Interest on debt or loan appears in loans as a percentage or as a fixed payment added to the principal. It is the most widespread kind of interest. Interest of debt unavoidably causes an injustice either to the borrower or to the lender since it is based on an uncertain outcome. When a borrower does not earn enough to pay the fixed rate, interest on debt causes harm to the borrower; then, it can be described as an "unearned income."

'Unequally distributed income'

When a borrower earns unexpectedly high income thanks to a loan, interest on debt causes harm this time to the lender; then, and turns that earning into "unequally distributed income." Hence, there is no difference between a 1 percent interest rate or 100 percent rate of interest. This is because any high interest rate may be an injustice to a borrower in unfavorable economic conditions and any low rate, which is mostly favored may be an injustice for lenders. As for the interest on exchange, as mentioned above, it occurs on the exchange of goods and the exchange of currencies. The interest on exchange is well defined in summary by Prophet Muhammad's saying. This concise saying is so comprehensive that it even includes the "interest on debt" that occurs on loans in addition to the interest on exchange transactions.

In this prophetic saying gold and silver represent all currencies and financial securities, and four other commodities stand for all standard goods. Based on this saying, besides the interest on debt or loan known to all, the Prophet Muhammad introduced interest on exchange transactions that occur in all on-credit-exchanges of goods for goods and currencies for currencies. Time or delay is pointed to by the Prophet as the primary reason for value differentiation between two exchanged items thereby a value transfer from one party to the other. There is only one permissible exception to on-credit-exchanges such as goods for money or money for goods transactions, as we buy some goods on credit for delayed monetary payment or sometimes we pay money today and the delivery of goods is made at a future date. This permission meets the need of people without ready purchasing power for pressing daily needs. “Interest on exchange” makes the Islamic approach to interest original and distinctive.

This saying suggests that all the futures such as forward rate agreements, and exchanges of financial derivatives for each other without corresponding to any real value increase in the underlying real assets on which derivatives are based, also include interest. For example selling €100 for a delayed $130 includes interest since there is a difference between the current and future rates of exchange on that transaction, resulting in an unproduced value not derived from the production of the good or income transfer from one party to another, making it a zero sum game. Another example is the exchange of a certain amount of oil for a certain amount of cotton on credit. Similarly, the exchange of loans of different amounts or with different rates gives way to interest like the derivatives so widespread in developed countries, in the US particularly. The exception to this is a “swap” wherein two loans of the same quantity and of the same term are traded. Or two in-kind debts can be settled at the exchange rate of the transaction day.

The 2008 financial crisis

A more concrete example for the burst of the financial bubble that resulted to the 2008 financial crisis is the sale of financial certificates with different interest rates and different times for each other. For example, the sale of a financial certificate of $100 --with a 5 percent rate of interest and for one year period -- in return for another certificate of $100 --but this time with a 10 percent rate of interest and for two years time-- bears a value transfer from one party to another by the size of the interest rate. Thus, a financial bubble begins to arise if the nominal increase in the value of the financial certificate due to interest payment is not balanced with a real value increase in the underlying assets such as houses. As known, houses have been the most frequently used as underlying assets upon which the financial certificates or derivatives are based on in the US and other countries.

There are two stages in a mortgage transaction. The first one is a trade that is the sale of a house to a client. The second and consequent stages are simply interest bearing and bubble building processes. As a basic real economic activity, trade is the process of purchase and sale that increases “location value” or “ownership value” of a commodity with the intention of making a profit. When you buy a commodity from its producer and sell it to consumers it is increasing the ownership value. When you buy orange for TL 1 per kilo in Antalya and sell it for TL 1.5 in İstanbul it is increasing the location value because it is more valuable in İstanbul. So, trade is “increasing the time value of commodity” when a house is bought by the bank on the spot, say for $100,000, and it is sold on credit to a client, say for $110,000, who otherwise could only obtain it months or years later with his regular savings. Thanks to this transaction, the client begins to benefit from the house immediately. The client's additional payment, which makes up bank profits, say 10 percent, is in return for the real increase in the time value of the home, with client gaining time value due to being able to utilize the home right away thanks to the bank's trade.

But when receivables -- in our example the receivable of $110, 000 -- are not kept in the safe of the bank and when they are sold to a mortgage firm at a discount, there begins the process of interest and bubble building because mortgage firms sell these receivables in derivatives markets at higher prices for longer terms and interest rates by slicing them into small pieces. To prevent the process of creating financial bubbles, it is necessary to limit all delayed sales of these securities at different interest rates and time periods and keep these securities in the vaults of the bank until they are paid by the clients, as in Turkey during the 2008 financial crisis, which left the country very far from the damage of the crisis and it now exhibits the second highest development rate in the world. Yet Turkey was subjected to downgrading by Standard and Poor's and Moody's for not having a local derivatives market before the crisis, but is now being admired for being the least affected from the crisis.

What interest policy lead to

Is interest policy responsible for the 2008 global financial crisis? We can definitely answer “Yes” when looking at the matter from an Islamic perspective that has a very precise definition and description of interest and its kinds, as described above, particularly with the kind of interest of exchange. Since interest is a process of a value or income transfer from one party to another without any comparable matching, interest-bearing transactions result in financial and economic imbalances between individuals, social groups, factors of production as well as nations in a process of lending or exchanges. These imbalances appear eventually as bubbles and crises in the financial markets when they cannot be sustained.

The alternatives to interest-bearing transactions are many kinds of trade, partnership and leasing, each yielding income of profit or rental fee instead of interest. These are mainly, mudaraba, musharaka, murabaha, bai muajjal (deferred sale), salam, istisna' and ijara (leasing),

Mudaraba is a partnership where one party provides the funds while the other provides expertise and management. Any profit is shared between the two parties on a preapproved ratio, while loss is borne by the provider of the capital. Musharaka is a joint venture between two (or more) parties to contribute to a particular investment enterprise where profit is shared in accordance with the agreement between the parties and loss is shared in proportion to relative shares of capital. Mudaraba and musharaka are the most favored modes of finance in Islamic finance. Murabaha, which is the most widespread mode, is the sale of a commodity by a bank to a client on mutually agreed profit. Bai muajjal is a credit sale of goods where a bank purchases a commodity on behalf of a client and then sells it to the client at a profit. The payment of sale price is deferred for a fixed period and may be made in installments.

Salam is a pre-paid purchase of goods in order to finance production by Islamic banks. Here the price of a future standard commodity is paid at the time of the contract, delivery taking place at a future date. This mode enables entrepreneurs to sell their output to the bank at a lower price in advance, thus having a ready purchasing power for pressing needs. The bank then orders the producer to sell output to usual client on its behalf. Similar salam, istisna'a is a contractual agreement for manufacturing nonstandard goods and commodities, allowing cash payment in advance and future delivery. It can be used for providing the facility of financing the manufacture or construction of houses, plants, projects, and building of bridges, roads, and highways. Ijara is an arrangement of leasing equipment, buildings or other durable assets to a client.

While loans of traditional banks do not necessarily enter the real economy, each monetary or financial transaction in the Islamic finance and banking system inevitably corresponds to a real economic activity, In Islamic economics, interest income is substituted with profit, rental, commission, and wage, all of which are regarded as legitimate earnings of trade, its derivatives, joint venture and partnerships, leasing, and other lawful and real economic activities. What makes profit legitimate is that it accrues to monetary capital in real economic activity on condition that it contributes to national revenue. As for rental, it accrues to durable capital as an initially determined income since the productivity of capital goods is direct and certain. Thus rental is a fixed income that is based on certain and fixed productivity. In profit and rental, there is a balance between income and productivity, hence a balance between income received and contribution to national revenue.

On the other hand interest accrues on loanable funds even when there is no contribution to national revenue thereby; and when there is contribution it is not necessarily as much as is earned. It is almost impossible to balance between interest income and productivity of monetary capital. This is because interest is an initially fixed income based on uncertainties, thereby resulting in unequal distribution of income and macroeconomic instabilities. While there is no “give and take” balance in interest income, there is an established “give and take” balance in the general sense in profit and rental, including wage and commission.

The crisis-preventive nature of interest-free modes of finance contributes to economic stability and common welfare. More importantly, Islamic banking can be a bridge between Western communities and Muslim societies, thereby contributing to world peace as well as to the common welfare. The roots of this cooperation are available in the common origins of the Jewish, Christian and Islamic traditions that prohibit interest. Having resisted interest for 1,500 years, longer than the lifetime of Islam, the Vatican accomplished a historic feat by suggesting the Islamic finance and banking system to the current Western financial world. This step can be regarded as the beginning of a new age when the whole of mankind can expect a better future in terms of peace and socio-economic welfare for all. Economists and finance authorities had better not wait for a second call from the Vatican to take the switch to Islamic finance and banking.


* Professor İsmail Özsoy is an instructor at Fatih University's department of economics.