In this chapter we discuss our main rationale for writing this book and introduce the reader to the two worlds of finance.
1.1 Overview
One of the main reasons we decided to write this book was because we had observed a lack of texts that analyze Islamic finance using mathematical rigor. More specifically, we wanted to show how the discipline of mechanism design could be applied to various cases in Islamic finance. It is understood that Islamic finance has differences from conventional methods of conducting finance today, but we think that the implications of these differences are not well explored. We felt this choice of methodology was necessary because it helps to provide a solid theoretical foundation for performing any other sort of analysis in terms of testable hypotheses, simple comparative statics and basic policy implications. We first introduce the subject matter by comparing the relevant differences between the two “worlds” of finance. Subsequently, we familiarize the reader with the Islamic “world” of finance, and describe the available instruments, ways of conducting financial engineering, and the operation of its financial system. Lastly, we introduce the reader to the main tools of modern economic theory—game theory and mechanism design—to show how they can be applied to Islamic finance.
1.2 The Two Worlds of Finance
We think that an extensive discussion of the differences between Islamic finance and mainstream finance today is not necessary as it would encompass various other fields which are far beyond the scope of this book. The differences we consider important can be divided into two categories, namely behavioral and operational. By behavioral we mean the factors taken into account by economic agents in terms of their mental accounting or, put another way, what they consider to be utility and disutility. By operational we mean the available market mechanisms through which agents can maximize their utility.
In terms of behavioral differences, most of them stem from the fact that Islam recognizes the existence of an all-superior being. The implications of this, which we would like to highlight, is that Islamic finance explicitly acknowledges the limited rationality of given agents and that their utility is subject to complying with the demands of the said being. However, Islam also acknowledges that the effect of this compliance also depends on agents’ levels of “trust” or “belief”. One example of how these implications can affect the utility function and other behavioral aspects of decision making concerns the Islamic concept of a “Day of Reckoning”. This turns agents’ utility maximization problems into a multi-period one where every action not only influences agents’ terminal utilities but also enters directly into their utilities in the final period. This is simply the idea that if their actions comply with the demands of the all-superior being, they will receive an additional positive utility and vice versa in the final period. Another way agents can be affected is that they can be considered as dividing their resources between market activities and “faith-building” activities.
In terms of operational differences, the main ones can be drawn from the conditions of a valid sale according to Islamic law. Usmani (2007) lists ten conditions:
- 1.The object of sale must be in existence at the time of sale.
- 2.The object of sale must be in the ownership of the seller at the time of sale.
- 3.The object of sale must be in the physical or constructive possession of the seller when it is sold to another person.
- 4.The sale contract must be finalized on the spot.
- 5.The object of sale must be a property of value.
- 6.The object of sale should not be a thing that is used exclusively for activities prohibited by Islamic law.
- 7.The object of sale must be specifically known and identified to the buyer.
- 8.The delivery of the sold commodity to the buyer must be certain and should not depend on a contingency or chance.
- 9.The certainty of price is a necessary condition for the validity of a sale.
- 10.The sale must be unconditional.
These conditions directly shape the securities available in an Islamic finance world, which will be discussed in the next chapter, but also provide subtle, environmental constraints that pervade all dealings related to Islamic finance. While they are more of interest to legal professionals, some of them cannot be excluded from more complex models such as those related to financial engineering. For example, in application to the asset market, provisions 1–3 will prohibit short sales without the permission of the actual owner of the asset. Under the assumption that asset returns follow a joint normal distribution, such a restriction will be unnecessarily restrictive and will prevent the traders from efficient risk sharing. However, as we will argue in this book, if returns to the assets have a maximally skewed stable distribution, a rational trader facing unlimited liability will choose not to engage in short-selling behavior. Under these conditions, these provisions can be seen as improving the welfare of boundedly rational traders. In relation to the fifth condition, money is not recognized as having intrinsic value and so does not enjoy the status of a valid commodity. One of the restrictions it has compared to commodities is that it can only be traded at spot. This effectively removes the conventional idea of bonds and derivatives from one’s permissible choice of assets and limits one’s choice of conventional liquidity management instruments. As we will discuss later, assuming perfect capital markets, the unavailability of bonds is irrelevant, since the Modigliani–Miller theorem guarantees the equivalence of debt and equity contracts. The equivalence, however, breaks in the presence of private information. Provisions 4–8 are designed to exclude trading in hot air and pyramid schemes and they play an important role in societies with a weak legal system and where there is uncertainty concerning contract enforcement. However, they exclude the possibility of contingent commodities, which play an important role in achieving efficient risk sharing in the face of uncertainty in Arrow–Debreu markets.
1.3 The Rationale of Islamic Finance
If we consider the ten conditions of sale above, we can infer that Islamic law places a heavy emphasis on the soundness of the contract. For example, seven of the aforementioned conditions basically ensure that the seller actually has something worth the buyer’s money, whereas the other three facilitate the soundness and upholding of the contract. More generally, scholars have recognized that one of the objectives of Islamic law is in fact the preservation of wealth. This is not to say that Islamic law prescribes economic stagnation and autarky, rather that one’s wealth should increase through gains from trade and not economically insubstantial market maneuvers such as hoarding. To explain this in terms more relevant to finance, the literature often consolidates the ten conditions into more substantial principles, such as in Kettell (2010). We find that these conditions can be summarized into three principles, namely the prohibition of ribā (excess interest), the prohibition of gharar (contractual uncertainty) and the prohibition of maysir (insubstantial economic activity).
1.3.1 The Development of Islamic Banking Worldwide
Islamic Banking and Finance (IBF) is the fastest growing industry of the financial arena and has been experiencing exponential growth in three parts of the world, including the Middle East, South Asia and Southeast Asia. In the African region, Sudan has been the torchbearer of IBF affairs over the past three decades. IBF practices have also been making headway in North America, Europe and Australia. This section will provide a general review of the recent developments of IBF in terms of products, systems, infrastructure and markets across the globe (Khan and Bhatti 2008).
The development of IBF reflects the persistent efforts made by Islamic scholars and institutions to find shariah-compliant means and measures for eliminating interest in economic and financial dealing in the Muslim world. Islamic scholars such as Qureshi (1946); Siddiqi (1948) and Ahmad (1952) pioneered the idea of practicing Islamic banking in modern times. Uzair (1955) made a major breakthrough by developing a more accomplished IBF model that explained the depositer–banker and the banker–entrepreneur relationship under the mudārabah principle. His work laid the foundation for the development and growth of the system along modern lines. Meanwhile, the Kuwait Investment House project and subsequent literature contributed by Huda (1964), Mannan (1970) and Udovitch (1970) elaborated and presented a mechanism which thoroughly replaced the conventional model with the Islamic banking one (Khan and Bhatti 2008). However, as we will explain later in this book, mudārabah imposes a constraint on possible principal–agent contracts, which limits the possibilities for the optimal trade-off between risk-sharing and incentives.
The Mit-Ghamar Sosial Bank, established in Egypt in 1963, may be regarded as a pioneer of contemporary investment. The operations of this bank were in trade and industry on a profit and loss (PLS) basis, with the bank appearing to be very successful due to increasing community support. Within a short time it developed nine branches, managing funds to the value of 1. 8 million Egyptian pounds, held for more than 250, 000 depositors. The experiment, however, was abandoned in 1967 for political reasons. The Pilgrimage Management Fund Board undertook a similar experiment by establishing Tabung Haji in Malaysia in 1963 with a total deposits of RM46,600 (US$12,000). The shareholders of Tabung Haji pooled their funds to invest in business and trade activities on the basis of risk-sharing. The core objective of the creation of Tabung Haji was to provide financial assistance to its members so they could make pilgrimages to Mecca (Khan and Bhatti 2008). In addition to this, Tabung Haji has played a significant role for savings purposes among Muslim people in Malaysia. Up till now, it has served as one of the biggest Islamic financial institutions in Malaysia. For example, the value of the total savings for Tabung Haji was RM10.5 billion in 2001, RM13.3 billion in 2006 and so on in 2016 it reach to RM60 billion with average annual increase of RM4.5 billions. The total of its financial resources also went up by 32. 9 %, increasing from RM900 million in 1999 to more than RM60 billion in 2016 with more than 100 branches.
The practice of IBF acquired significant shape and momentum by the end of the 1970s due to increases in the general economic prosperity of Middle Eastern countries, primarily from the influx of petrodollars into the region. The Middle East Islamic financial institutions (IFIs) system received increasing sociopolitical and economic support for the growth and prosperity of many reputable banks which came into being, including the Nasser Social Bank Cairo (1971–1972), the Islamic Development Bank (1975), Dubai Islamic bank (1975), Kuwait Finance House (1977), Faisal Islamic bank of Sudan (1977) and Dar-Al-Maal Al-Islami (1980).
The development of Islamic finance activities is mainly crowded around three regions of the world, which include the Middle East, South...