Is Islamic finance answer to crisis?

THE HOTTEST TOPIC in the Islamic intellectual world in the West is whether the financial meltdown and Wall Street collapse of the last year would not have happened if we had an Islamic system of finance instead of 20th Century capitalism. The answer is clearly yes, but for two mutually exclusive reasons. On the one hand, it is clear that, properly employed, Quranic restrictions would have prevented the excesses of leverage and gambling on derivatives that led to the current collapse; on the other hand, however, those same restrictions would have prevented our Western economies from reaching anywhere near the levels of size and complexity we enjoy that make it possible for such enormous problems to occur.

As a threshold matter, it is important to remember that Islamic law is at once ancient and modern. From its origins in the Quran and the words and acts of the Prophet Mohammed in the early 7th century, up until around the end of the 1st Millennium, it was unquestionably the most advanced body of law, as well as civilization in general, west of China (other than, perhaps, Byzantium). However, for theological reasons, it then entered a nearly 1,000-year-long period of constricted growth that only really ended for the Shi’a in the 19th Century and for the Sunni much more recently.

During that period, the Dark Ages ended in the West and the Renaissance and the Enlightenment ushered in not only nation-state democracy, but also modern capitalism. The real economic evolution started when Western merchant banking developed in Italy, in the 13th Century. In fact, our word “bank” comes from the benches (bancas) that the Medicis and others set up starting in the 14th Century. As Western financing vehicles advanced from these early compagnias to unincorporated associations, the evolution of the entity theory of partnership law and then incorporated entities, and finally, in the 20th Century, limited-liability structures, in Islam there was very little movement from the traditional forms developed in the 8th and 9th centuries.

Islamic finance is therefore still imbued with the principles of the 7th Century Quran. The most important is (whether or not honored in the breach) the concept of “social justice” or “social responsibility.” This means that relationships in the economic sphere must be based on the same ideals of fairness, honesty and charity that govern a person’s religious obligations as well as his relationships with other people. The most famous post-Enlightenment Western expression of this might be Marx’s “from each according to his ability, to each according to his need.” But unlike Marx and Engels, Mohammed and his disciples had nothing against profit being retained by enterprise owners. What they did forbid was (and therefore is) riba and gharar — interest and excess or unquantifiable risk.

For 1,000 years, Muslim scholars virtually unanimously interpreted that the prohibition on riba means that both charging and paying interest is a forbidden activity (haram). And since unlike the Jewish and Christian Bibles, every word of the Quran is the literal word of God, it is a divine edict, not a statutory or constitutional one. Therefore, finding safe ways around an express prohibition like riba is not a simple matter. Gharar is less precisely defined, and therefore more flexible. But some of the major aspects of modern finance that are covered by gharar’s prohibitions are gambling, promises to make loans or investments in the future based on conditions that are not certain to occur, pledges of currently non-existent collateral and property, casualty and life insurance.

One result of these prohibitions is that Islamic banking has developed very differently from Western models. First of all, they cannot finance in any way enterprises engaged in prohibited activities, such as alcohol, gambling and pork production, or any business predicated on the paying or charging of interest. Nevertheless, as today’s Islamic societies discovered that capital formation is needed to expand their economies, they had to confront the issues successfully navigated by Western capitalism 700 years before: the difference between “usury” and “interest.”

The capitalist solution was based on the realization that there are two aspects of interest: the risk value of money (the risk that the borrower will not repay it in full or at all) and the time value of money (ability to generate profits using the money over the time it is in the hands of the borrower). While the former, arguably, can be associated with social justice in that it involves an important aspect of trusting one’s borrower’s promises, the latter clearly does not.

In 1980, when I drafted the model loan documents for Saudi American Bank, basically all I had to do was change the word “interest” to “commission” throughout the documents. That would not work today. The level and scope of Islamic finance and banking has exploded exponentially. Yet, while there has been tremendous creative efforts made to find ways to use the traditional, 1,000-year-old vehicles (basically different forms of partnership, including mutual insurance pools [takaful]), the basic limitations of riba and gharar remain major obstacles to the development of Islamic finance within the current international finance system. And despite those efforts, including the hermeneutical investigations of ancient Arabic to re-translate those terms, there is nothing approaching a consensus on the horizon to change the traditional rules.

Legislating greed out of profit-seeking would certainly be a major blow to Wall Street. However, it would also be a major blow to entrepreneurship, as well as require a tectonic shift in human nature. And even then, there is still the issue of the failure to take into account the mathematical imperatives of the time value of loaned and invested capital. Without that, you can have equity investments, which derive profit from taking the speculative risk that the investment itself will increase in value, but you cannot have secured or unsecured lending.

So Islamic finance and banking remove one of the essential underpinnings of wide-scale capital formation — risk-averse capital. Their adoption would therefore end not only over-leveraged markets that lead to bursting bubbles but most of the rest of those markets as well.

Robert E. Michael is an international insolvency and finance lawyer who has created and led the Islamic law program at the New York City Bar Association.