Ben Dyson explains how banks make 92% of their investments in non-productive businesses, like speculative property bubbles, which has led to the massive unemployment that we see and repetitive boom and bust cycles. 



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Uploaded by PositiveMoneyUK 

January 10, 2012



Ben Dyson gives clear answers to 3 Key Questions: 



1) Who creates money? 



2) How much money do they create? 



3) What do they do with the money they create?



He shares some very interesting and profoundly important facts and shows how far the reality of banking is away from the text-book model of banking and which major implications the current system has on our lives.



How do banks create money out of nothing? How do they create money as debt? Has money been privatized?



We recommend it as an educational tool and encourage the widest distribution and use by all groups concerned with the present unsustainable monetary system.



Presented at the Positive Money Conference in London.



More Information:



www.positivemoney.org.uk

Gerald Celente talks to Lew Rockwell about his top trend forecast for 2012.

Posted November 30, 2011

“It is clear that we should be self-sufficient and not rely on debt. That we should live more simply, consume more wisely, think of generations to come, and wonder what desires we want to plant in children’s hearts…..Bringing decency back into debates, normalcy into pay rates (checking greed), and ancient truths into temples is going to take a fight.” At first look, these words appear to be from a long-bearded, fanatic mullah sitting in the Yemeni desert or ‘law-less region’ on Af-Pak border. But these views are expressed in a recent Newsweek column by a young, blonde American journalist/writer Julia Baird. Her message is crisp and clear: the whole world is dying for a change. Not change of names; not change of faces; not change of titles. But change of the present system that the ‘civilized world’ has practiced for about four centuries and is now committed to impose, even by force, on the ‘uncivilized world’!

The Challenge:

A handful of financial whiz kids, through opaque algorithmic magic, are minting money while hundreds of millions of hard-working, skilled and honest individuals are loosing jobs, further affecting many more millions in their families. In spite of the downturn, in the US the rich are indeed getting richer, according to an analysis of new data by economists Thomas Piketty of the Paris School of Economics and Emmanuel Saez of the University of California, Berkeley. Their report revealed that two-thirds of the US’s total income gains from 2002-07 went to the top 1 per cent of households, with this top tier holding a larger share of income in 2007 than at any time since 1928.

The findings released by the Center on Budget and Policy Priorities show that during those five years the inflation-adjusted income of top 1 percent of households increased more than 10 times faster than the income of the bottom 90 percent of households. Please read once again. It is bottom 90 percent households and not any specific faith group. These households most certainly include Christians, Jews, Hindus, Muslims and followers of other religions. The system is almost equally cruel to all faiths. The last time such a big share of the income gain went to the top 1 percent – and such a small share went to the bottom 90 per cent – was in the 1920s! This proves that depression, recession, contraction etc. are meant to hit ordinary folks only while rich get richer during these economic downturns.

The world has 1,011 billionaires in 2010, up from 793 a year ago, according to the Forbes annual list of the world's richest people released in March 2010. The United States has 403 billionaires, the most in the world. My incredible India – home to the largest humans living under poverty line in the world – has 10 of Asia's top 25 billionaires! China is no different. It has the second highest number of billionaires in the world while urban Chinese earn an average of US$ 1800 and rural Chinese US$ 758 per year only! Wall Street Journal reported in April 2010 that the worldwide sale of super yachts – toys for rich boys – was up in 2009 compared to 2008. The collective wealth of Britain’s 1000 richest people also increased by 30%, the Sunday Times Rich List said. Their combined

wealth rose by more than GBP 77 billion since 2009 to GBP 333.5 billion, the biggest annual rise in the list’s 22 year history.

It is not just daddies (and few mommies) who are hungry for money. Their kids are naturally following their footsteps. The evangelical author Jim Wallis cites a 2006 study, in his new book Rediscovering Values: On Wall Street, Main Street and Your Street. The study found that in 2006, two-thirds more high-school students thought “having lots of money” was “extremely important” than just a generation back said the same in 1976. This rapid descent to the culture of greed i.e. wealth at any cost has brought us to the brink of disaster. Today’s high-school kids are teachers, doctors, lawyers, civil servants, corporate and political leaders of tomorrow. They are our future. What kind of a society will they sculpt, is a critical question that must be addressed forthwith.

The feelings of disgust at this state are not restricted to only 'thinkers'. Even members of showbiz are realizing the gravity of crime prevailing system is facilitating. American comedienne Joan Rivers recently blasted Victoria Beckham, the celebrity wife of soccer star David Beckham saying "I am not a fan of outrageous consumption. I think it is vulgar. No one should flaunt that they have a 100 Hermes 6,000 pound bags. Not when people are starving." Yes, you are right: 6000 pound means approximately Indian Rs 420,000 per handbag. And she is not the only one who has them in hundreds. But the point is that such a criminally extravagant lifestyle is a natural outcome of too much and too easy money that the present system allows a handful of us to earn. At a new year party a couple of months back at a gutkha (chewing tobacco) baron's farmhouse near Delhi, bollywood czar Shah Rukh Khan reportedly charged INR 5 crore for a 30 minute leg shaking appearance. Yes, over one million dollar for a 30 minute dance!

The issue is not that we have less wealth in the society. We have plenty. The problem is its massive concentration in too few and too selfish hands.

Pre-Solution:

History tells us that more or less similar gloom prevailed in the 6th century Arabian Peninsula. Human values were completely absent. Greed and selfishness was at its peak. Among others, two of the seven social sins listed by India’s founding father Gandhi (i) wealth without work and (ii) commerce without morality were particularly present. But one individual changed all this. His name was Muhammad. It is impossible to understand the relevance of Prophet Muhammad (peace and blessings of Allah be upon him and his family) without grasping the basic ideology that he successfully practiced and preached within a short span of less than a quarter of a century, to almost one third of humanity of his time. We need not get into finer details of his religion. That will require a book, at the very least!

Let me use one very recent example to highlight the centerpiece of Muhammad’s ideology i.e. sense of accountability to our Lord on the Day of Judgment for every single deed. This ideological belief is meant to shape our behavior in this world. The print and electronic media is full of stories about a recent cold-blooded murder committed by the-one-and-only rogue state that exists on the planet today. Although the murderers got away from the scene of crime, they left behind an electronic trail of their movement in the country where this heinous crime was committed. And they must be watching wherever they are, as the whole world is, the footprints they left behind. That is it!

If someone had to tell us just about 100 years back that a time would come when every move of ours will be recorded and all matters will be decided on the basis of this hard evidence, we would have never believed. Muhammad said exactly this about 1400 years back that there are video cameras all around us. They are recording every single act of ours. Be watchful of your behavior. Based on this life-long recording, there will be reward or retribution when our lives come to an end.

In the context of economic challenges the world is facing today, let’s pick-up the cornerstones of Muhammad’s philosophy. If practiced sincerely by Muslims first and then aped by non-Muslims, will help make this world a better place. In my view, these are broadly four and they are inter-connected; more so because they originate from the same centerpiece. And these are not based on rocket science that only Harvard or MIT graduates can practice. These are simple, yet difficult, ‘inner engineering’ or behavioral solutions to current economic challenges. They do not require super computers; they only need super determination that motivates us to think of others. The Prophet established the golden principle: "Make it easier, not harder." (Bukhari)

The reason why most of us do not do good is: “what is the point?” And: “no one cares.” Very true; if we take a pedestrian view. However, Muhammad’s followers are supposed to have a deep sense of accountability that there will be a Day of Judgment when all good deeds will be rewarded. On the contrary, there will be retribution for a behavior lacking compassion. This is the centerpiece of Islamic way of life. Without religiously practicing this belief, one cannot be a Muslim.

Cornerstones of economic solution

ZAKAH SADAQAH

(Obedience) (Sacrifice)

Accountability

WAQF INHERITANCE

(Generosity) (Compassion)

Muhammad challenged the establishment of his time. Ruling elites – like today’s – attempted to buyout the person who wanted to change the system of exploitation; the system of nepotism; the system of corruption. He was offered all the wealth of his home town Makkah – a thriving city like Dubai or Hong Kong in terms of trade volumes. He

refused. He was threatened and persecuted for 13 long years. He migrated empty-handed, in the dead of night! Declining a ‘lucrative deal’ was possible only due to his strong belief in accountability on the Day of Resurrection.

He laid the foundation of a state in the present Saudi city of Madina, a 3 hour drive from my house. His mission was so simple; so pure and so appealing that the state grew from less than a 100 square kilometer to over a million square kilometer within a decade. Total loss of human life in this expansion of justice-led peace from both his side and his adversaries’ was little over 1000. He knew that political and social justice will remain only dreams in the absence of economic justice. Like a prudent economist, he crafted his economic policy on the basis of four self-sustaining and value-driven cornerstones namely, Zakah, Sadaqah, Waqf and Inheritance.

Prophetic Solution I:

The institution of zakah is the core of Islamic economic system. It is a micro economic solution to deal with macro economic challenges i.e. unemployment and poverty. Zakah literally means purification. When applied on wealth, it is meant to purify our earnings/assets annually. A fixed percentage payoff is mandatory on every Muslim having his/her networth above a certain threshold (which is not very high). Zakah is deeply rooted in the Islamic culture despite an economically fragile state of Muslims in general. Prophet Muhammad and his successors used force against affluent Muslims if and when they refused to pay this share of underprivileged and weak in their wealth. Almost all the seven categories of zakah recipients are needy and underprivileged.

In Islamic states, the authorities are allowed to force high networth individuals/corporates to pay annual zakah. This economic self-help system eliminates utter poverty and starvation leading to a morally and socially healthier society. Wealthy non-Muslims do not pay zakah, even in an Islamic state. However, economically weak non-Muslims may receive zakah in both Islamic and non-Islamic states.

Zakah increases money circulation in the society. It gives purchasing power to those who are unable to generate it on their own. It is important to note that zakah is not meant to be used up on consumption alone. The preferred use of zakah is to economically empower the recipient so that s/he soon becomes a contributor to rather than remaining a recipient of zakah. It is the responsibility of the contributor to ensure that the recipient becomes economically self-reliant. For optimum results, it is better to distribute zakah in an institutionalized form rather than individually. For responsibilities like these, a large group of efficient and ethical persons is needed. If there is shortage of such folks, our priority should be to develop human capital from grassroots level. Yes, I mean through top quality schools which produce more ethical and efficient generations than ours. Sitting back and waiting for such people to emerge out of the blue is not an option.

Prophetic Solution II:

Life and death is routine. Every moment, thousands of humans are entering and exiting this world. The second micro economic solution to the present economic challenges relates to timely and fair distribution of inheritance. Unlike zakah, there is no minimum threshold of assets for inheritance distribution. Every bit should be shared among the wife, children and other inheritors of the deceased. The Qur’an commands us to divide the smallest of assets (Chapter 4). This is another effective mechanism to discourage concentration of wealth in fewer hands. In reality, the ‘smartest’ or the greediest walks away with all or most of the assets left by the family head. This not only leads to economic deprivation for some, but also results in enormous social and legal costs.

However, religiously sticking to the rule requires love for justice and fair play rather than love for money and pleasure. This is again directly connected to having strong faith on the Day of Judgment when all violators will realize their mistakes. But it will be too late for them to regret. There is a graphical punishment mentioned in Qur’an for those who delay or do not distribute the inheritance as per the detailed guidance of Muhammad.

Prophetic Solution III:

The third solution relates to voluntary (and unlimited charity). This solution is very strongly connected to the Islamic worldview: this world/life is just a transit point. This philosophy dictates our behavior in almost every aspect including economic matters. More than two-thirds of humanity is barely surviving on 1 dollar a day or even less. On the contrary, about 1% super-rich control almost 2/3rd of the global income and wealth. This level of economic disparity is driving some of us nuts. Human beings are usually not greedy. Although the ‘civilized world’ makes us believe that we are inherently greedy. But I can say with certainty that most of us in the ‘uncivilized world’ are not! They are content with a respectable life where most of their needs and few comforts are met with dignity. But when hundreds of millions of dollars (thousands of crores INR) of illegally earned wealth is recovered from serving politicians – the Chief Ministers and Chief Secretaries and IAS and IPS Officers – this is proof enough that our governance system (from which flows the economic system) is rotting and requires a surgical solution.

From start to finish, Prophetic life is an example of selfless and compassionate character. Despite heading a rapidly expanding and increasingly rich state, he did not leave behind fat bank accounts; big chunks of real estate; gold and jewelry; industries or businesses. He lived like a traveler. He gave away whatever wealth came to him. This is one of the reasons why he is fondly remembered as a Prophet of mercy by over 1.5 billion Muslims every day. Non-Muslims admire his simplicity and humility even after 1400 years of his departure from the scene. How many billionaires are remembered with love and respect after they die? On the contrary, most of them are either hated for all the wrong means they used in accumulating their wealth or they are cursed by their own offspring/inheritors for ‘not leaving enough’!

Prophet Muhammad created enormous sense of love for eternal life among his followers. They would go out of the way to spend their rightfully earned money generously on others. He once asked his companions “who among you love his wealth more than the wealth of his inheritors?” Everyone replied, “all of us love our own wealth over our inheritors’”. He said “your wealth is only what you have remitted to the life after death i.e. given away to the poor and needy” (Bukhari). His teachings and his own practice created a society where wealthy competed to keep for themselves as little as possible and give away as much as possible.

Prophetic Solution IV:

Muhammad was acknowledged as Amin (trustworthy) by even his adversaries. In line with Islamic belief, he used all resources at his disposal as a trustee of God and not as an absolute owner. This approach fundamentally shifts the direction of economic affairs. Whatever one ‘owns’ is to be utilized within a framework of rights and obligations; fulfilling one’s own needs, and of the family, as well as fulfilling the rights of other human beings, society, state and humanity.

A hardworking, selfless and honest society always creates surplus wealth. We witness this even among individuals and smaller groups around us. When such a society is not into indulgences of life (buying 6000 pound handbags or spending one million dollar on a 30 minute dance show) then the only way they can use their wealth is by helping less privileged human beings. Islamic history is full of tangible evidences that numerous endowments, schools, hospitals and other social infrastructure were created through waqf i.e. donation of large properties or businesses for general welfare of the society (not just Muslims). Worldwide waqf assets (including in India) are worth tens of billions of dollars. If managed honestly and efficiently as a proper trust, they can generate enough regular income to meet many genuine needs of the society.

Let us bear in mind that these present waqfs are only indicative of our past glory. For a present and future vibrant society, it is essential to persuade our millionaires and billionaires – in the light of statements and practices of Prophet Muhammad – to give away as much as possible before they return empty-handed to their Lord.

Conclusion:

Prophet Muhammad was not a socialist or a communist. He was not against private ownership. Nor was he adverse to profit making. His focus was economic justice. He knew the reality of life that human beings are not equal in talent, energy, skills and knowledge. Some have a right to earn and spend more than others. But earnings must be rightful and spending must be judicious. Muhammad presented a strong, categorical and permanent moral filter for sourcing and using funds. Extravagant lifestyle is not in sync with Islamic values when millions are starving.

The same Prophet who prayed to his God for refuge from poverty, also prayed: "O God, grant me life as a poor man, make me die as a poor man and resurrect me in the company of the poor." His wife asked him why he said that. He replied: “Because (the poor) will enter Paradise (before) the rich.” He continued “Do not turn away a poor man even if all you can give is half a date. If you love the poor and bring them near you, God will bring you near Him on the Day of Resurrection.” (Tirmidhi)

The above economic solutions are purely internal. No demonstrations, agitations or begging for job reservations are required. Through counseling and setting right examples, peace and wider prosperity can still be restored. It is impossible to attract non-Muslims towards Muhammad (peace and blessings of Allah be upon him and his family) and his philosophy, if his own followers are in deep economic mess as a result of ignoring the above principles of Islam. 

Nafis Alam is currently attached to the School of Business at Monash University Sunway campus, where he works as Lecturer (Islamic Finance) and has also embarked on a PhD program in Islamic Finance. Nafis has co-authored the ?Encyclopedia of Islamic Finance? which is a first of its kind.

Islamic banks operating under the guided principles of Islamic economics have succeeded where all others have failed, withstanding the US subprime mortgage crisis which left global markets shattered. Islamic banks had shunned collateralized debt obligations linked to subprime, or high risk, mortgages because such complex instruments do not comply with the Shari?ah. Global conventional banks from Citigroup to UBS have written down more than US$80 billion in credit market losses since October 2008 as defaults on subprime mortgages triggered a credit crisis that is tipping the global economy into recession. By contrast lenders in the Gulf and Malaysia, the global hubs of Islamic finance, have reported minimal or no subprime related losses. The subprime crisis could provide the Islamic banking industry with greater opportunity for growth, both from conventional retail customers looking for an alternative, and also from the collapse of conventional asset prices.

Current Financial Crisis and Islamic Economics

The current crisis emanating from US financial markets and spreading to other developed and fast developing countries like Japan,

European countries and Singapore, is threatening a global meltdown leaving the entire world poorer and with grim forebodings of the future. It started as a credit crunch due to highly over-stretched leverage, was aggravated by the complexity of the products and reached its peak due to moral failure generating conflicts of interest and mismatch between incentives of the various groups and individuals involved in the scheme.

It can be argued that debt-finance coupled with speculative products whose particulars defy understanding provide ample opportunities to greedy profit-maximizing agents to exploit the aspirations of ordinary investors and for goading home owners and consumers into living beyond their means and chasing unsustainable dreams. A world of banking and finance without Riba and Maysir can be suggested as the best alternative to the current scenario. In this new environment risk sharing will replace risk shifting and morality, advising people to be moderate in their material pursuits and considerate about public good in their private decisions, coupled with realism, will serve as the corrective to self-destructive outgrowths of current financial capitalism. It can be also noted that for this alternative model to be robust and resilient, morality has to be rooted in spirituality. This will provide a basis for willing acceptance of social norms, state supervision, regulation and intervention in the market based on values rather than interests.

Currently, financial institutions include banks, investment companies, insurance companies etc. managed by hired professionals. Those who govern financial conglomerates by virtue of owning enough shares have motives different from ordinary shareholders. Almost the entire population in developed countries is involved in supplying capital through purchase of stocks, bonds, insurance policies, pension funds, etc. While these ?principals are interested in profits they care about many other things too, among them stability, jobs, social justice, and anxiety free communities. Not so the hired managers who consider profit maximization to be their mission as it earns them maximum bonus and continued employment. There are those amongst middlemen who earn fees. They earn more when transactions multiply. In an environment where no one cares about others, focused as everyone is on his or her own interest, public interest is supposedly guarded by regulators.

If we go deep into the roots of the crisis, we can consider Maysir infested financial products like Credit Default Swaps (CDS), the inverted pyramid of debts and the shortage of liquidity, all the features of the current situation, are rooted in the moral failure as described above. It could have been different. The underlying reason can be found in the separation of economic life from morality after the secularization of society in the wake of the so-called age of enlightenment. Islamic civilization has the instruments to pre-commit man in society to certain values leading to rules i.e. abolition of interest and gambling.

Why does Islamic finance prohibits Maysir or gambling? Firstly, gambling does not create additional wealth. Games of chance only transfer wealth from its (losing) owners to new (winning) ones. Considering the human resources consumed in the process, wealth transfers through games of chance cannot be considered to be efficient. They do not serve any social purpose. Other absolving circumstances like the revenue to state in form of taxes or employment generated by casinos, lotteries, etc. cannot be considered as advantageous until the acceptability of gambling itself is established.

Risk shifting can also be considered as a form of gambling. One who buys risk exchanges a definite amount of money (the price) for an uncertain amount of money, whose delivery itself is not certain. CDS are an appropriate example. The millions of loans made by a bank are each subject to the risk of default (credit risk) in various degrees. The risks attached to each loan are unique. The institution undertaking to pay for all defaulters among, say a million borrowers has no scientific basis for measuring the risk it is taking. There is no long history to fall back on. The law of large numbers does not apply. It is just taking chances, gambling. The banks that so protect themselves against credit risks are emboldened to give more and more loans. That is how aggressive lending policy gained an impetus. The sub-prime mortgage crisis would not have occurred without the speculative deals like CDS. Aggressive lenders offered to refinance mortgages on the basis of rising home prices, virtually converting owned homes into ATM machines, sending people on a buying spree, some of it on instalment purchase basis, encouraging an expansion that had little basis in the fundamentals: earning powers, disposable incomes and savings and investments.

The Islamic approach to risk is realistic but cautious. It does not allow deals involving excessive uncertainty (Gharar). It encourages sharing arrangements for facing risks. The additional wealth created with the use of existing wealth through risky ventures should be shared between fund users and fund owners while both bear the risks involved and the resulting losses. Differences in the participants? perception of risks involved will be decisive in determining the terms of bargain between those sharing risks. Even though the motive of each party is making profits, it is very different from taking chances in gambling. There is real wealth to be created, real gain to be reaped. It is different in case of risk shifting as in CDS. Neither the buyer nor the seller of risk has any stakes in real wealth creation. As in gambling only one party actually gains, either the seller of risk or the buyer. It is different in risk sharing in which both parties gain (or lose). Like gambling, risk shifting is a zero sum game.

Risk sharing fits in with a system that integrates risk management with value creation. The Islamic institutions of Musharakah, and Mudarabah, for example target value creation and are good ways of managing risk. In a healthy venture fear of loss works to counter-balance hope for gain. When a system allows shifting the risk at a cost the fear factor becomes inoperative in so far as the seller of risk is concerned. It is worse when the government takes over the risk similar to what happened in case of Fannie Mae and Freddie Mac in USA. Such a system is heavily leaned towards the rich and leads to greater inequality as it protects the lenders but leaves the borrowers to fend for themselves. This is the feature of the current system that led to an almost universal blubber in that it amounted to privatizing gain and socializing pain.

In this context we can refer to an Islamic approach as encapsulated in verse 278-281 of the second chapter of the Quran:

?Believers! Have fear of Allah and give up all outstanding interest if you do truly believe. But if you fail to do so, then be warned of war from Allah and His Messenger. If you repent even now, you have the right of return of your capital; neither will you do wrong nor will you be wronged. But if the debtor is in straitened circumstances, let him have respite until the time of ease; and whatever you remit by way of charity is better for you, if only you know.? [2:278-81]

In effect the above is advising how to handle a crisis caused by default. A crisis like the sub-prime crisis in US (if it ever occurred in an Islamic interest free system based on risk sharing) would be handled not by extending credit to lenders but by giving more time to borrowers and writing off some of the debts.

Islamic finance could have prevented subprime crisis

The global economic crisis sparked by the US subprime mortgage meltdown would not have occurred if Islamic principles were applied in international financial markets, as noted and confirmed by many Islamic scholars. Defaults in the US market from risky mortgages have caused major global credit turmoil, as massive US losses led to a squeeze on international credit markets, and subsequent fall in global equity markets.

The mortgage crisis would have been unthinkable under Islamic principles because crises such as this would technically be unthinkable in the Islamic capital markets sector as it would be against Shariah principles to sell a debt against a debt. The subprime mortgage crisis had seen trillions of dollars traded without the backing of assets. If such transactions followed the Islamic finance model it would have easily prevented the current economic crisis.

The subprime mortgage debt write downs have had a crippling effect on economies the world over. They have raised the cost of debt and, therefore, access to finance and, more importantly, increased the cost of living. Subprime mortgage debt write downs and their subsequent large scale affects the world over, were for the most part, attributed to two factors: the first being the relaxing of mortgage credit criteria in developed economies on the assumption that real estate prices were on the rise and therefore there was sufficient collateral to risk providing loans to individuals without a substantial credit standing. The second reason was the role of the financial markets in the securitisation and subsequent repackaging of such mortgage-based obligations into all types of securities with numerous tranches (or seniority status), without a substantial or exact trace to the underlying assets of the securities. These, in turn, awakened a sleeping tsunami in the financial industry, including the substantial malpractices of highly geared Investment banks, which potentially suffered from questionable risk management practices. More importantly, it raised questions on the integrity of the sophisticated financial system the modern world has developed over the past decade, a system in which the regulators are trying desperately to catch up with market innovation, particularly in the space of derivatives and debt markets. Another school of thought is emerging which characterises this largely to the role of speculators in the derivative markets. They stressed that the lacklustre performance of the real estate and equities markets in the developed world has resulted in traders shifting their attention to commodities, which are proving to generate substantial returns. A large part of this commodities trading is done on futures markets, which some conjecture may have a substantial effect on today?s prices, since current demand may be driven by future expectations of prices.

Two of the features of the current crisis would not have existed in pure Islamic economies based on sound Islamic financial principles. For one, the trading of debt, as in the case of the mortgage backed securities is seen as usurious in the domain of Islamic commercial jurisprudence. Hence, the re-packaging of debt obligations into several layers without a substantial trace to the underlying asset is largely frowned upon by Shariah scholars. Islamic bonds, carrying unique structure features, cannot fall victim of a crisis such as subprime mortgage crisis. Subprime mortgages are backed by dubiously rated collateralized debt packages which subsequently precipitated a global credit crunch. Islamic finance principles stipulate that deals must be based on tangible assets and require tight controls on debt levels, features analysts say offer some protection to investors and ensure corporate accountability. Islamic securities should be asset-based. A direct link to the asset is the substantial basis of the asset generating returns, although this may not be true for all Islamic securities, which have largely succumbed to the influences of conventional securities.

Second, futures-markets trading are largely disallowed. Goods that do not exist, goods that the seller does not own or cannot deliver cannot be the subject matter of an Islamic contract, which means all types of futures contracts are disallowed in Islamic economies. The only exceptions to this rule are the contract to construct (only applies to specific customisable goods made to order, not commodities) and the contract better known as Salam, which allows for future delivery of non-existent fungible commodities, albeit with extensive prohibitions including the full payment of the price in advance.

That full payment has to be made upfront in Salam is itself a great disincentive to engage in speculative trading unless there is a genuine need for the underlying commodity by the buyer. Even if there is no genuine need by the buyer of the commodities and the buyer would like to speculate by holding the assets, Islamic commercial law disallows the trading of such future obligations until the asset is actually delivered. This is markedly prohibitive compared with the conventional futures trading in the West, which allows for futures trading without payment and without settlement until the contractual date.

A commitment to Islamic finance can come from those individuals who believe not only in its visible ethical and social justice rules but also in the greater wisdom of the divine source, regardless of whether the benefits of such rules are apparent or measurable. While we wait for the empirical evidence to turn up on the causes of these economic crises, perhaps we should ponder on whether these rules laying down certain limits on Islamic finance do have some divine sources behind them; wisdom that is able to foresee the macro-economic effects of our micro-economic decisions such as the trading of a simple obligation.

Thus it can be seen that the Islamic finance system, which introduces greater discipline into the economy and links credit expansion to the growth of the real economy, is capable of minimizing the severity and frequency of financial crises such as the subprime crisis.

Financing extended through Islamic products can expand only in step with the rise of the real economy and thereby help curb excessive credit expansion. The significance of the condition that prevents a creditor from transferring the risk to someone else by selling the debt will help eliminate a great deal of speculative and derivative transactions where there is no intention of giving or taking delivery. It will also help prevent an unnecessary explosion in the volume and value of transactions and the debt from rising far above the size of the real economy.

It will also release a greater volume of financial resources for the real economic sectors and, thereby, help expand employment and self-employment opportunities and the production of need-fulfilling goods and services.

The discipline that Islam wishes to introduce in the financial system may not materialize unless the governments concerned reduce their borrowing from the central bank to a level that is in harmony with the goal of price and financial stability. In an Islamic system, credit is primarily for the purchase of real goods and services which the seller owns and possesses and the buyer wishes to take delivery.

© Islamic Finance Today

Muhammad Ayub is the Author of a well known work on Islamic Finance Understanding Islamic Finance (2007). He is the Former Head of Islamic Banking, National Institute of Islamic Banking and Finance (NIBAF) and Senior Joint Director, Islamic Banking Department, State Bank of Pakistan

Corporate Finance’ is related to the relationship between business decisions and the value of shares of the firm in the business. Corporate managers, investment bankers and the financial analysts have to make a number of decisions in any financial environment – conventional or Islamic. Islamic Corporate Finance activities of investment institutions are similar to conventional corporate finance except that the products and services offered are Shari´ah compliant.  The decisions may pertain to the following major activities:

i)    What investments a firm should  make of funds

ii)    How can funds be arranged to pay for investment decisions – internal and external sources

iii)    Raising private and public funds

iv)    Securitization – Equity, Sukuk issues

v)    What should be reward policy in case the business is successful

vi)    Financial restructuring

vii)    Acquisitions, divestments, mergers

With Islamic banking and finance emerging vastly, the corporate firms and finance managers are required to have conceptual clarity about the bases of Islamic finance and develop analytical skills to evaluate corporate finance decisions for Shariah compliance and for safeguarding the interests of all major stake holders – shareholders, financiers and financial intermediaries.

Three main decisions taken by any corporate firms are investment decision, financing decision, and the dividend decision that are inter-related in the long run and, therefore, should be solved together. Investment decision is, however, more important as it alone affects the firm’s value.

The sources of funds can be divided into the new funds raised (financing decision) and the flow of funds from operations of the business (part of the investment decision). The use of funds can also be divided into two parts, i.e. asset and non asset expenditure (the other part of investment decisions) and payment to the shareholders (dividend decision). In terms of investment decisions, companies working in Islamic finance framework cannot invest in conventional financial products, gambling, short selling and Haram and immoral items and activities relating to pork, alcohol, pornography, etc.

The basic contracts used in Islamic finance are i) loans, ii) selling goods on credit or forward purchases thus creating debts, iii) leasing the assets against rentals; iv) equity based financing for sharing of profits and absorbing business losses; and v) fee or commission based agency services. A large number of products are being used by Islamic financial institutions (IFIs) either singly or as combination of various modes.

An Islamic finance manager must have clear views on nature and Shariah position of some critical issues like sale of debt, receivables / monetary assets, financial options, swaps and hedge funds that could play a decisive role achieving the level of Shariah compliance in investment and financing activities. He has to keep in view the following principles of Islamic finance:

1.    Loaning is a virtuous act and not a business mode in Islamic finance because of prohibition of interest. Any types of funds taken in the shape of loans have to be guaranteed to the extent of principal without provision of any return – return and reward go side by side.

2.    Trade based contracts entitle fixed return to the banks as price of goods has to be stipulated without any ambiguity at the time of execution of any sale. While fixing the price, IFIs can keep in view the time involved for performance by the client. While credit price of the goods can genuinely be higher (as in case of Murabaha), forward price in Salam can be lower than their spot payment price of the goods. Prices of goods have to be stipulated without any ambiguity at the time of execution of any sale. Bai al Inah (sell and buy-back) is prohibited due to being a trick to circumvent the prohibition of interest. Tawarruq (getting cash through purchase and sale) is legally permissible according to the majority of the contemporary Shari´ah scholars. But essential conditions of valid sales must be fulfilled.

3.    In Ijarah (leasing), the lessor has to bear the ownership related expenses and risks of the leased assets. It can be used directly for plants & machinery, and indirectly for Sukuk issues by public and private sector corporations. In the arrangement of ‘Sale & Lease Back’ a corporate body may sell an asset to an IFI or SPV and then lease it back to get the required finance.

4.    In partnership modes, profit to any partner cannot be in the form of a fixed amount or any percentage of the capital employed and the loss has to be borne by the investor(s) pro-rata with the proportion of the invested capital.

5.    IFIs have to bear the asset risk, market risk and all counter party risks – they can manage to mitigate but not eliminate such business risks. Once the contract is executed, they have to give or receive delivery/possession irrespective of upward or downward movement of the prices. If general rate of return or price levels in the economy rise, they can loose in terms of Murabaha receivables as prices once finalised cannot be increased.

6.    Short selling as facilitated and practiced by brokers in conventional finance is not allowed. One must have ownership and possession of what he is selling. Salam (forward sale) of goods of certain nature that do not exist and are not in possession of the seller is allowed, but subject to conditions relating to quality, quantity, availability of the wares in the market, pre-payment of the full price and delivery of the Salam commodity at stipulated date irrespective of the price movement in the market. Further, the subject matter in sales must be valid assets. Accordingly, all transactions in which exposure to the parties is only the difference between the agreed price / interest rate and the settlement price / rate applicable at the date of settlement are not acceptable in Islamic finance.

7.    Arbun sale in which the seller takes a part of the settled price of an item of sale (earnest money) from the buyer with the understanding that the earnest money will be credited to the agreed price if the sale is concluded, and forfeited if not concluded, is allowed according to the contemporary Shariah scholars associated with the IFIs. But the question is: can the purchaser, after paying the earnest money to the seller, dispose of the item before finally purchasing and taking the same in his possession? In my view it should not be allowed as a policy because it is more likely to become a back-door for selling goods without taking ownership and possession and ultimately corrupt the investment practices of IFIs.

This view is based on a precedent that Shaikh Taqi Usmani had earlier allowed (in T+ 3 days settlement framework) on-ward sale (prior to final settlement) of shares purchased with firm commitment to conclude the deal on payment of margin. But Islamic banks practically mis-utilized the permission and resorted to serious irregularities leading to non-Shariah compliance. Therefore, Shaikh Usmani had to reconsider the issue and advise the banks to dispose of the shares only after making full payment on the settlement day.

In case of Arbun, where the very intention negates the firm commitment to buy, it is more likely that any open permission may lead to unethical practices and fictitious deals by a series of maneuvering between the brokers and the investment managers. Some efforts have been made to operate Islamic hedge funds on the basis of Arbun, but due care needs to be taken in coordination with the Shariah boards to ensure Shariah compliance.

8.    Sale of debts and receivables is not allowed except at their face value along with recourse to the original debtor. Similarly all instruments based on asset portfolios representing cash and debts more than 33 % are not eligible for trading as per screening criteria approved by AAOIFI and Shariah Committees of Islamic investment funds and companies.

Islamic financial market instruments are mainly of two types in terms of their nature and flow of return: Fixed/ Quasi Fixed (Stable) Income Securities based on trade and Ijarah based modes. These instruments accommodate risk-averse investors and generate resources for additional intermediation and income flow to the banks; and Variable Income securities based on partnership modes that offer a stream of variable income based on the strength of the underlying projects.

Trading in the above instruments is subject to the following principles:

a)        Instruments representing real physical assets and usufructs are negotiable at market price. Certificates or Sukuk issued on the basis of Musharakah, Mudarabah and Ijarah are covered under this category.

b)        Instruments that represent receivables  and  money  are subject to the rules of Hawalah (at face value with recourse to the original debtor) and Bai´ al Sarf (exchange of monetary units : hand to hand in case of different currencies and equal for equal as also hand to hand in case of same monetary unit on both sides).

c)    Instruments representing a pool of different categories are subject to the rules relating to the dominant category. If cash and debts / receivables are relatively larger, the rule of Bai´ al Sarf would apply, and if real/physical assets and usufructs are overwhelming, trading would be based on the market price.

Shariah scholars have developed certain investment criteria for investment that pertain to portfolio selection keeping in view the nature of business and certain financial ratios. These criteria require that: i) Prohibited activities such as gambling, interest-based financial institutions, alcohol production etc must be excluded; ii) The investee company’s capital structure should be predominantly equity based.  These criteria might be different in different jurisdictions as decided by the scholars on the basis of tolerance level in different financial markets depending on the nature of financing and the level of development of capital markets in respective areas.

Time value of money is accepted to the extent of pricing of goods and their usufruct and not in the form of ‘opportunity cost’ or the ‘cost of funds’ in the sense of interest based finance. This concept is important in CF to determine the present value of cash flows expected in the future in the process of business. It has direct bearing on the pricing benchmarks adopted by IFIs. The trade-off between money now and the money later depends on, among other things, the rate one can earn by investment.

The benchmarks play an important role in deciding the profit sharing ratio in partnership modes as also in respect of finding out the future value in investment for a number of periods in debt-creating trade and Ijarah based modes – IRR, NPV and profitability of the firms and in making financing, investment and dividend decisions.  Corporate finance experts have to try to evolve benchmarks based on real sector activities in the economies so that Islamic banking and finance could yield real benefits for all stakeholders.

Although Shariah scholars have allowed using the conventional benchmarks for pricing of goods and their usufructs, such benchmarks reflective of the fictitious assets may not be helpful in achieving the real objectives of Islamic banking and finance.

It is hoped that the above explanations will be helpful in understanding the nature of corporate finance practices in an Islamic finance framework.

Shaukat  Amer is Assistant Professor of the Department of    Management Sciences, COMSATS Institute of Information Technology,  Attock Campus –Pakistan. He has spoken and written  extensively on Islamic  Accounting  Theory and Principles and on Corporate Governance based on Islamic Valuese

Today at a time of economic and financial crises, it is high time that we revamped present business and management theories and principles in line with Islamic principles and so mend our severed relationship with Allah. The love and fear of Allah is the foundation of all wisdom and this should be the basis for all theories and principles that seek to guide human endeavour. This will not only address governance issues but it is also possible that new ideas for achieving organizational goals in the right direction would emerge. This will also help to avert situations of economic and financial crises. The Qur’an and Sunnah could certainly help us to explore these opportunities. In this respect there are three immediate tasks that need to be taken in hand. These are:

1-    Development of a New Financial System which create real economies instead of bubble economies through Islamic concept of creation of value to avoid economic and financial crises.

2-    A New form of Business Organization replacing the present corporate form of business organization to resolve governance issues which normally arise due to limited liability and separation of management from the ownership.

3-    Development of a new accounting theory based on Islamic principles.

These are three urgent and important tasks which need to be addressed. Our aim should be to develop different disciplines which could ultimately replace present theories and practices in the exploitation-oriented business world so that non-Muslims may also benefit. We need not necessarily use words like Islamic finance, Islamic accounting, Islamic marketing, Islamic trade and management etc. Our work should be of such nature that the non-Muslim world would be obliged to embrace these disciplines as well.

The present financial system based on interest is largely responsible for the economic and financial crises the world has faced from time to time.  Interest should not be considered merely as a fixed addition to the principal amount; rather it includes all unjustified increments arising out of transactions prohibited under the teachings of Islam. The present financial system by nature promotes speculative business. This is mainly facilitated through creation of money by financial institutions and investment in stock markets without any reference to creation of value through producing more and more goods and services. This results in bubble economies which in turn leads to economic crises such as we witnessed recently.

Islamic teachings on the subject of “bay” strongly promote transactions which create value as it mainly deals with the valuation aspect of business transactions. If we study the ahadith related to “bay” a message is conveyed that settlement of transactions in “bay” will lead us to settle financial transactions in a justified manner which will in return also create value. So we may call it “Principle of Equal Settlement and Value Creation”. We can build a new financial system on the foundation of this concept.

Further all the Islamic financing arrangements encourage creation of goods and services.      Therefore, it is rightly said by Mufti Taqi Usmani in his book Islamic Finance that one of the most important characteristics of Islamic financing is that it is an asset-based financing.  So we need a new financial system which creates real economies through achieving real growth. In this respect the Islamic concept of creation of value (I call it ‘Principle of Equal Settlement and Value Creation) and Islamic financing arrangements (both basic and non basic modes of finance) can provide a solid foundation for the development of a new financial system.

However, this is not possible without extensive conceptual work in the light of  Quran and Sunnah under the methodology of Usul-ud-Deen. The uphill task in this respect is to invent a new mode of money which itself has value so that it should maintain the notion of “value create value”. This will entirely change the present scenario of simple creation of money in the financial market without any reference to creation of value.

The new financial system will also bring stability to the financial markets as these will deal in goods and services having real value instead of speculative transactions.
Now we come to the need for the development of a new accounting theory based on Islamic principles. In order to make successful business decisions, the following roles must be performed by accounting:

1     Keeping Safe Custody of Interests of all the Stake Holders. This is more than Book-Keeping.

2    Accurate Valuation of Business Transactions
3    Certifying the True and Fair View of Business to all the Stakeholders.

4    Enabling Accountability of all the Stakeholders.

5    Providing Reliable Information for Successful Decision Making to all the Stakeholders.

However, the present accounting profession has desperately failed to perform these functions. Accounting is normally defined as a process of identifying, measuring, recording, classifying and summarizing business transactions which make it possible to achieve its major goal of financial reporting to the stakeholders for decision making. In the context of present criticism of accounting, the financial reporting on the affairs of an entity have a very special meaning. Accounting testifies to the correctness and fairness of business transactions to the parties to whom these are related.

Unfortunately, the present accounting profession often comes under pressure from the management to do its bidding in manipulating accounts which has damaged its concept of “true and fair view”. This has also limited its certification scope. Even within the framework of GAAP or International Accounting and Reporting Standards, the management with the help of accountants often manipulate accounting information to deceive other stake holders in order to meet its fraudulent objectives. Testifying to the correctness and fairness of business transactions in its actual and true spirit is the basis of all financial reporting. If the financial reports cannot testify to the correctness and fairness of business transactions to its stakeholders then it denies them its most vital role.

Normally it is said that accounting is required for valuation and it has nothing to do with accountability. This is a misconception since without proper accountability a business transaction can not be valued correctly. Accounting based on the Islamic Principle of Amanah dictates that the interests of all the stake holders should be kept in the safe custody of a trustworthy person. This is more than mere book-keeping. Further one vested with such authority is also responsible for accurate valuation of business transactions. Regarding amanah or the Exercise of Trust Allah Subhanahu wa Ta’aala ordered human beings  “Lo! Allah commandeth you that ye restore deposits to their owners”(Surah Nisa, Ayah 58 of  The Holy Qur’an)

The Principle of ‘Shahadat’ dictates revealing a true and fair view of the business. Present–day accounting is not only responsible for recording, classifying and summarizing business transactions accurately, but also to report on financial affairs as the final outcome of this process. The starting point in the system is identifying and recording of business transactions correctly on the basis of objective evidence so that the financial information which would be based on these records may be reliable and may be helpful for decision making. Accordingly we have to apply the Principle of ‘Shahadat from the very beginning. This will result in a just course of action for business affairs which would ultimately result in true and fair financial reporting. Ultimately this will help to discourage malpractices like off balance sheet reporting.In the context of development of a new accounting theory based on Islamic teachings, the principles of  ‘Amanah’ and ‘Shahadat’  can play an important role in performing its due role as outlined here. The principle of ‘Amanah’ will ensure automatic accountability while valuating the business transactions which will lead it to its correct valuation while the principle of ‘Shahadat’ will certify correctly the true and fair view of business and provide reliable information to the stakeholders for successful decision making. The “Principle of Equal Settlement”, as in case of development of a new financial system, is similarly innovative in development of a new accounting theory/setting accounting standards (This principle is equally useful in other fields of management like marketing, HR and international business). This principle deals with the valuation of business transactions in a justified and correct manner as it is based on Divine guidance.

Thus this will be equally helpful in valuation of business transactions under the scope of accounting. Islam has a unique concept of mutual consultation i.e. ‘shura’ which can provide a strong base and guidance for setting accounting standards.In simple words a business transaction can be defined as a business activity which can be expressed in monetary terms. However, the main issue attached to a transaction is that it should be valued in a most objective manner, maintained properly and reported correctly. In every business transaction, something is being exchanged in monetary terms in exchange for another thing in monetary terms. It means that we are exchanging value in exchange of value. This principle of ‘Equal Settlement’ has been derived from the ahadith which mainly deal with the valuation aspect of a business transaction. The ahkam or rules in these ahadith basically relate to bay transactions. However, as these relate to valuation and settlement of transactions, these may also serve as guidelines to set accounting standards for valuation and settlement of business transactions. These ahadith give us a clear message how bay transactions should be valued in a most objective manner. We should remember that the concept of bay has a very broad meaning in Islam and is not restricted to trade only.

Islam has a unique system of mutual consultation (Shura) to run the affairs of the world. The Qur’an, while describing the qualities of the Muminun (believers) includes those  “who (conduct) their affairs by mutual consultation”(Verse 38 Ash-Shura). Since there would be a need for a body to set accounting standards based on accounting theory in line with the Islamic principles discussed here, we propose that this body work in line with the Islamic concept of Shura.

The corporate form of business organization is coming under heavy fire nowadays, and not just from intellectuals, but even ordinary folk who are becoming wary of the increasing influence of corporate entities in their day to day life. A company’s distinct features of limited liability and separation of management from ownership has made this possible. All the major issues of corporate governance  are created due to these two peculiar characteristics. There is no doubt that the corporate form of business organization has brought a revolution in the business world which is unprecedented in human history. However, the limited liability concept easily bails out the management for their wrongdoings which may result in severe losses either to creditors or to the share holders. So in the context of Islamic teachings, it is rightly said that  the limited liability concept  is not simply denial of huqooq (rights) of creditors only but is also a denial of huqooq of all the stake holders and especially of share holders. In the context of separation of management from ownership it is said that shareholders have lost control over their own wealth and the officers have gained control of the wealth which they do not personally own. Even if we see the point of separation of management from ownership parallel to the concept of Mudarib (Manager) and Rabb-ul-Mal (Investor), the losses to owners by the fraudulent acts or negligence of managers can not be justified

In the corporate form of organization shareholders are the real owners but they are not involved in the day to day affairs of the business due to separation of management from the ownership. They elect a Board of Directors as their representatives to represent their interests. Unfortunately in the first instance there is always an issue of shareholders activism especially in the case of individual shareholders and outside corporate structure. In the second instance their elected representative i.e. BOD (Board of Directors) do not often discharge their full responsibilities. In real terms instead of monitoring management of a company on behalf of its owners i.e. shareholders, they patronize the chief executive of the company and other management for various reasons and benefits. This is where Islamic modules such as Mudarabah can come in. The relationship between Mudarib (Manager) and Rabb-ul-Mal (Investor) can be used as a basis for inventing a new form of business organization.  A new organization based on this relationship will automatically disapprove the wrong doings of the management. Further in this case the management will also be responsible for any liabilities that may arise due to fraudulent management practices and negligence. The present trend of the world economy has made the future of mankind very gloomy indeed.

The emerging scenario is detrimental not just for Muslims, but the world at large. This is borne out by the present economic crisis which has put in danger the wellbeing of a good many economies regardless of their affiliations. Thus there is an urgent need to change the philosophy of doing business from maximization of wealth of owners to maximization of wealth of the larger society. We should remember that the message of Islam is to care for each and everyone. It is therefore high time that we applied Islamic concepts into our economic life.