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Collateral in Islamic Finance

Posted on 18th July 2012 by Camille Paldi,

Plaza de Torros Before Sunrise (Madrid, Spain)

 

Thought String from Iraj Toutounchian’s Islamic Money & Banking: Integrating Money in Capital Theory

The Place of Interest in Capitalist Economics

“Western economists treat interest as if it were a necessary and unavoidable aspect of every economic system, as a common string to tie all economic activities together and without which the system collapses.

This belief might be true for capitalism, bearing in mind Sir Dennis Robertson’s comment about Keynes’ work raising the rate of interest ‘to a position of commanding theoretical importance.’  Obviously, there are many elements of truth in Keynes’ analysis of capitalism; yet this should not prevent us from reconsidering the place of interest in that system.  Let us begin by returning to basic economic principles.  We assume a country with one huge firm whose factors of production are labor, capital, land, and entrepreneurship…The monetary value of the output produced is to be allocated among the factors of production on the basis of their respective contributions.

In a primitive society where the owners of the firms are also the managers, this kind of income distribution makes sense.  But what about in modern societies, where stockholders (the real owners) may not even know the managers of the corporations?  In such cases, critical issues develop that require correcting:

1. The managers are not the owners of the profits earned, although they may be highly skilled and earn high incomes.  They may enjoy profit-sharing privileges, or be given a proportion of the increased sales income, or of the decreased cost arising as a result of their competence and qualifications.  Whichever the case may be, the managers are part of the labor force, however skilled.  Therefore, they have to be included under the heading ‘labor.’  This modification leaves ‘profit’ an unassigned income for which the proper owner has to be found.  The issue is a serious one because if profits are a reward to entrepreneurs, what is left to be paid to the stock-holders?  Interest, perhaps?  Definitely not.  Interest is paid to bond-holders, not to stockholders.  Bond-holders are not the owners of firms, but stockholders are.  This means that the profit is also theirs.  They are the ones who run the risk of incurring loss but, as long as debts are based on collateral, bond-holders assume no risk whatsoever.  These problems lead us to the second issue.

2. It has often been stated by Western economists that ‘interest’ is the ‘price of capital.’  However, interest is the price of a sum of money borrowed to put into the firm or used for speculative purposes.  We cannot be sure that all borrowed money will be converted into actual ‘capital.’  As long as it is not entered into a firm and put into the production function, it cannot be considered as ‘capital.’  The legalities, as distinct from the technicalities, of the production function are important issues that are often neglected.  A common and perhaps deliberate failure to distinguish the legal difference(s) between money and capital, and their respective returns, has become the source of considerable confusion and misconception.  Interest is basically determined in the money market because of its being speculated upon.  There seem to be no doubt that explaining the forces which determine the interest rate has been one of the major problems facing economists.”  (94)

Speculation

“The term ‘speculation’ is used here to mean any action which, for the benefit of the few and to the detriment of the general public, alters the normal course of events in a money economy to make it an unsound and unhealthy economy.  Unhealthy events are those which, sooner or later, bring about instability and the crises of confidence, which afflict the economy.  Speculation harms public confidence because of the nature of the speculators’ expectations about the future course of the rate of interest.  Speculators normally earn money income by attempting to ‘buy cheap and sell dear.’  ‘Speculation’ as it is used here follows the way Keynes used it in his General Theory.  To be specific, almost all transactions in stock markets involving the exchange of stocks whose prices are market-based are speculation.  The exception to this is the exchange of stocks issued by firms and sold when stock prices closely match the real value of the firm and not the market value of the stocks.  The prices at which stocks are normally exchanged far exceed their real value as a result of bubbles.  The real value of stocks is the real value of the assets of the stock-issuing firm.  By this reckoning, ordinary stock markets that are secondary markets are, as I understand it, money markets; the primary markets, devoid of bubbles arising from speculation, are capital markets.  Capital markets are essential and necessary for any economic system, Islamic or otherwise.” (186)

Underlying Conditions for Success in Islamic Finance

“In the Islamic financial system, money does not earn any return without being legally converted into actual capital in collaboration with effort.  The proportionate returns for the investor, who provides part of the actual capital to undertake an investment project, and the bank which, on behalf of the depositors, provides the remainder, depends upon several factors such as the priority of the project in terms of value added or increase in employment, the degree of risk involved, social interests, and the like.  We will say more about these issues later.

In the interest-based conventional system, collateral is often required to guarantee the return of the principal and interest. 

This seems to be unproblematic as long as the value of the collateral exceeds that of the principal amount of the loan plus interest to cover any legal expenses in cases of default.  In theory, though not necessarily in practice, neither the lender nor the borrower cares about where the money is spent.  Trust and/or trustworthiness play no significant role as long as the above considerations are taken care of.  In the extreme case of the bankruptcy of the borrower, liquidation of the collateral is used as a source of ‘trust’ that the borrower’s debt will be collected.  The borrower strives to make more money than the amount borrowed.  The lender does not care about the outcome of the borrower’s activities, being concerned solely with the return of his money plus the interest charges.  Each side is independent of the other.  Yet this seeming positive is also negative in that their economic activities have social consequences for the communities in which they live.  These often manifest themselves in the form of an adverse impact on employment, higher prices, and the inequitable distribution of income and wealth.

Western welfare theorists such as Pareto have yet to provide evidence that society – that is interactions among individuals in a community – does not exist.  It is this failure to take account of such interactions that gives rise to conflicting interests.  Until the well-being of all individuals is tied together, a humane economic system cannot exist.  Separating individuals within a society requires a strong public sector to deal with the problems arising from inevitable conflicts.”  (241)

Collateral

“In the conventional banking system, ‘collateral’ is usually taken to mean the pledge of an acceptable (generally solid and redeemable) asset as security for a loan or credit.  But in the different philosophical setting of Islam, where people matter and man plays the central role, a different value system is practiced.  Here, ‘collateral’ is understood to stand for attainment of certainty and security based on the solid foundation of the transaction and good performance of the undertakings to minimize the risk to return on the capital.  In this context, the word ‘collateral’ is generally replaced by the phrase ‘sufficient security.’  The security needed here has much to do with proper utilization of the code of ethics combined with the intellectual property of the applicant – which has rarely, if ever, been used before.  As we saw in Chapter 1, the shareholders in a Musharakah contract never ask for collateral from the issuing firm since each of the shareholders has a proportionate claim on all assets of the firm.  Instalment sales provide another example, where the subject property itself is used as collateral until the bank’s resources have been fully redeemed.  As we also saw earlier, a Qard-ul-Hassan contract is basically a loan, but payment is made without taking any collateral.  In brief, any action taken by an Islamic bank is taken because it is considered to be the trustee agent or advocate for its depositors.

In any economic downturn, every participant in our Grand Cooperative System (GCS) has to bear a share of any losses; that is to say, everybody is made responsible for the rest of the community.  Similarly, in years of prosperity, everyone enjoys the benefits of cooperation in proportion to their respective contributions to the social product.  It is worth reiterating the fact that an Islamic bank exerts itself to the full to maximize the social welfare and maintain equity through cooperation.  The GCS is composed of numerous atomistic cooperatives whose goals are the same.  This, then, leads inevitably to a position outlined by Professor Gauthier as follows:

As we have seen, the best and most reliable ‘collateral’ is for intellectual property of the applicant who makes a proposal for a PLS contract.  Sufficient inbuilt security in the form of trust, combined with intellectual property and technical ability, renders the policy of the conventional system irrelevant.

Unlike conventional banks, an Islamic bank performs functions that are integrated into the whole economic system and thus is inseparable from the real sector.  In essence, it works as the development engine of the economy.  It also performs an investment-development bank whose functions vary, as we have seen, from the simple to the most complicated.  Profit maximization is not the goal.  Profit comes after an economy enters into a healthy stage.  We demonstrated earlier how full employment in this system is guaranteed through the abolition of interest and the absolute absence of speculation of any sort.  The transmission mechanism for this is the institution of the Islamic bank.  Its function makes efficiency and equity complementary, rather than conflicting, objectives.”  (263)


Posted on 18th July 2012 by Camille Paldi


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