THE PREACHER AND THE BANKER---Reappraising the Progress of Islamic Finance Industry

Mohammad Nejatullah Siddiqi

(January 2011)*


By all counts Islamic finance has done well during and after the financial crisis triggered by subprime lending in US and engulfing the world during 2007-09(?). I mean what counts conventionally. Is there something else that counts? That is a different story.

Economics is about incentives. Man is moved by many kinds of incentives: material, spiritual; mundane, other-worldly; individual, social, etc. Material incentives may relate to wealth, fame, power and privilege, etc. Economics specializes in dealing with material incentives, particularly those related to wealth. It is also best equipped to deal with individual/personal incentives (something it owes to its history over the last two centuries).  It works best where measurable sums of money are involved. It never claimed to deal with other kinds of incentives, especially spiritual ones. It is of little use here to lament these limitations or wish for a more ‘holistic’ approach. Better to use it where it serves and find other ways to deal with what is beyond (conventional) Economics.

Islam too deals with incentives. Though it concerns itself with all kinds of incentives, it gives special importance to spiritual and social incentives. Life’s multifarious needs cannot be all met by encouraging only individual-material-money- focused motivation. In fact this kind of short-sighted approach has been the bane of capitalism. Many a critique of the recent crisis has pointed out this affliction’s role in what happened. A search is on for forces that could limit, if not altogether eliminate the role of this deficiency. In fact the problem is not confined to crises, as capitalism has suffered from this disease from day one. Humanity has been led to believe(I think wrongly) that this affliction is the price we must pay for ‘progress’ at a rate without any precedent in human history, of creation of wealth at a monumental rate. That requires we ignore the fact that more than a billion people still suffer from abject poverty, let inequalities increase overtime bringing in its wake increasing crime and soring anxieties, and leave untreated the threat to world peace posed by existing and forthcoming hegemonies.

That is not going to be. The current paradigm can no longer sustain itself. It is at this point that we recall there is more to good life than individualistic-materialistic incentives can bring forth. Admittedly the cures are not simple. We need a methodology that ensures progress with equitable distribution of the fruits of progress. It is foolish to tolerate abject poverty and deprivation in an age of plenty. World peace is too valuable to be sacrificed for the sake of aggrandizement of any one people. The new approach cannot be effective unless its incentive structure accommodated the social nature of life on earth. In view of the fact that overwhelming majority of human beings believe and have always believed in life beyond death, spiritual dimension of motivation also deserves recognition.

Islam, and all world religions for that matter, wisely relied on spiritual and social incentives to meet the requirements of dimensions of life not amenable to individualistic material incentives. These incentives appeal to the individual, in the first instance. But these incentives also persuade the individuals to cooperate with one another for bettering their conditions (in this life and the life yet to come). This cooperation extended to finance too. As exemplified in early Islamic practice, such cooperation involved, besides individual economic agents, the state as well as voluntary organizations. Cooperation in finance was institutionalized in different kinds of partnerships, credit sales, lending (free of interest), and trade credit, etc. It is not always possible to replicate old institutions in new circumstances. What is important is to keep the spirit of cooperation alive and active, with an approach to wealth creation that sees wealth as means to good life, not as an end in itself. The translation of the cooperative approach into appropriate institutions can be different in different circumstances.

That is where all religions, Islam included, differ from capitalism. Once again the financial crisis of 2007-09(?) has demonstrated that capitalism is incapable of ensuring good life that would inclusive of entire humanity and cover the social and spiritual dimensions of life. The reason lies in capitalism’s incentive structure, which is one sided. Some think clever regulations can manipulate individualistic incentives to serve social objectives. It is good as far as it serves, but the record thus far has not been very encouraging. There is no escaping the conclusion that   social-moral orientation of man’s approach to wealth better start from the individual at the early stages of education. That is what religions have done since the dawn of civilization. Religions, Islam included, give us values (like justice, equity, social equality, compassion) which values have to be translated into institutions suitable for the time-space contexts in which these values are sought to be realized. The real challenge, intellectual as well as organizational, lies in devising suitable governance and regulatory structures that could complete the task begun in educational institutions of inculcating humane incentives in economic agents (consumers, savers, investors, entrepreneurs).

Religions rely on preaching rather than coercion. The intention is to preserve human freedoms. Islam wisely accommodated some coercion necessary to keep order. In finance it has laws like prohibition of interest and gambling to meet some minimum requirements of justice and fairness. But the realization of the larger objectives of Islam in finance requires broadening the incentives-structure. Islamic finance cannot succeed in its vocation on the basis of capitalistic incentives-structure. The realization of Islamic values of justice, equity, social equality, compassion,in contemporary society requires an imaginative exercise in social innovation that Islamic finance votaries have yet to attempt.

When the Islamic finance project was launched in the third-fourth quarter of the twentieth century it had the ambition to do exactly that. Instead of being a mere replica of capitalist finance, that accepted the sovereignty of profit motive, the guiding light of monetary advantage and the focus on the individual, Islamic finance aimed at serving the Islamic objectives of money and finance by eliminating interest and gambling like speculation, removing ambiguity from contracts and  facilitating cooperation and sharing among people. Islamic finance implied a culture of risk sharing by the wealth owners: the depositors into Islamic banks’ investment accounts and those seeking profits through Islamic mutual funds, sukuk, etc. The capitalist culture of seeking profits while refusing to share risks fits ill with the Islamic spirit and does not belong to Islam’s incentive structure. Is it possible to retain the capitalist culture and record progress in Islamic finance? Does Islamic finance involve sacrificing the vitality and forward surge of capitalist enterprise? Can we survive in the fiercely competitive environment of modern industrial society with a non-capitalistic incentive structure and less than capitalistic rates of growth? These are difficult questions indeed, but they have to be raised and dealt with.

A reappraisal of the Islamic finance industry along conventional/capitalist lines misses the distinctively Islamic features of the industry. Reappraising the progress of Islamic finance industry on the basis of Islam’s incentive-structure is beyond the scope of this brief note and too big an order for the limited capacities of this writer. It is a challenging task. It has some   complex dimensions. Understanding the information deficit and its role in contractual relations, especially agency relations, is one of these dimensions. Another one is to recognize herd mentality, irrational exuberance and other psychological aspects of human behavior in investment and stock-trading. Then there is the issue of misalignment of incentives between share-holders, managers and rating agencies, for example. Financial relations like risk sharing or lending ,at arm’s length take a different color as compared to financial relations established directly, on a person to person basis. Most of the Islamic precedents we draw upon for guidance belong to the latter category. How to institutionalize the spirit of human relations in a local community in the global village of impersonal dealings? These challenges to human ingenuity call for creative solutions. Most writers on finance are worried by  the growing distance between the financial sector and the real sector of the economy. With the rise of ‘shadow banking’—financial institutions functioning like banks but not regulated like banks—and dominance of ‘fictitious capital’ having no counterpart in the real economy, the resulting misallocation of resources and the concomitant worsening of income and wealth distribution have assumed crisis proportions. What remedy is possible?

Last but not the least: What do you do if the banker does not listen to the preacher? The easy way over the ages has been for the preacher to threaten with eternal damnation (hell on earth, hell thereafter). But that is not of much help for us, the ordinary folk who fear the preacher but need the banker. There must be a way out! The initial spurt of Islamic financial institutions as exemplified by Tabung Haji, the Mit Ghamr experiment and other community level institutions established in the nineteen sixties, bore the promise of becoming something distinctive. May be they could not meet the needs of impersonal financial relations at a global scale. Some other initiatives, preferably at state level, would have had better chances of success.  But the trillion dollar Islamic finance industry being reappraised by this forum is more of a dish in the standard menu, albeit with an ethnic flavor. Where did we slip?

A detailed answer must await special focus by competent scholars, but some observations are in order. For too long the industry has been focusing on product development, Shariah- compliant products in current parlance, to the neglect of building the institutional infra- structure needed by the new kind of finance. Islamic financial industry worth the name calls for institutions rooted in Islamic values and Islamic (dual) incentives, incentives that are not forgetful of spiritual-social objectives while they focus on material-individualist interests. Man’s environment does not force one to choose between the two: material/spiritual, individual/social. Good living implies a judicious mixture of the two. Balancing the two is what sustains the world despite our aberrations. With modern capitalism the balance has been lost. Islamic finance was conceived to regain balance. We can still do it by paying due attention to our values and objectives, inviting each and all to participate in the task of building appropriate institutions to support a humane society the treats wealth as a means to good life for all and sees finance as a necessary ingredient in this enterprise.




*Inputs from Professors Valeed Ansari (AMU) and Habib Ahmad (Durham) are gratefully acknowledged.