Saturday, October 15, 2005

Islamic Economic system: Readings for Final Examinination

Final Examination 26th October 2005
Islamic Financial System (45%)
Master of Economics and Finance
Kulliyyah of Economics and Management Science
International Islamic University Malaysia
Instructor: Prof. Saiful Azhar Rosly, Ph.D
Format of Examination: Essays only.
Answer any three out of eight (3 x 15 = 45)

Readings: Critical Issues on Islamic banking and financial markets & all power point slides presented in class.

From the book: Critical Issues on Islamic banking and financial markets
Section 1
Article: 4

Section 2:
Article: 4, 5, 6, 10

Section 5:
Article: 2, 6, 9,10, 30

Section 7
Article: 2, 3, 4,10, 12, 13.

Section 8
Article: 4,5,6,8,10.

Section 9
Article: 1,2,3.

Section 10
Article: 1,9,12,14,17, 18.23.

Other Readings : On your own
1. Murabahah Notes Issuance Facility (Munif)
2. Islamic credit cards
3. Islamic banking and Basel 1 & 2
4. Adverse selection in Islamic banking (in my blog)
5. Understand well balance sheet and income statement of non-financial companies

Tuesday, September 13, 2005

Mid-term Exam Islamic financial system MASTER OF ECONOMICS

The paper contain 2 sections:
1st Section - 25 Multiple choice questions (2 x 25 = 50 marks) - with problems/calculations
2nd Section - 4 essays - answer only two (2 x 25 = 50 marks)

Wednesday, August 17, 2005

Islam and Gambling (Maisir)

The main idea behind the prohibition of gambling (maisir) in Islam is that money should be earned by way of work and effort (kasb) i.e. knowledge and not by mere pure chance. The Quran says, “They question thee about strong drink (khamar) and games of chance (maisir). Say: In both is greaty sin, and (some) utility for men; but the sin in them is greater than their usefulness” (Al-Baqarah: 219)

When knowledge and skills are used to earn a livelihood, it exemplifies a life that gives due attention to morality and healthy living. This is because earning money by virtue of pure chance can mean two things:

Life under desperation
Life under recklessness

Life under desperation means an illusion that one will eventually win the lottery prize although by the law of large numbers, it is highly unlikely he will ever win it. This is the problem of the desperate poor.

And life under recklessness refers to the attitude of a risk-lover who is willing to put his money at risk knowing that the rewards are not commendable enough. This is the rich man problem some of whom readily finds thrills and excitement only in gambling.

Shariah scholars usually brought up the gambling issue as one of the underlying prohibitions of Islamic finance. Financial transactions implicated are:

Commodity forward trading
Financial futures and options

This short essay shall examine what is gambling and tries to see whether the above transactions embrace the salient features of gambling.

Playing a lottery is one form of gambling. There is not debate in the Islamic circle that it is not. However, there has been arguments and legal opinions (fatwas) that insurance, forward trading and financial derivatives are gambling.

Gambling include any activity where a person pays something of value for the chance to win a prize. When someone gambles, it will involve three things, namely:

Prize: anything of value: money, physical items, software
Consideration: what the person must pay to enter
Pure chance: something that is opposite to the pure skill. For example, chess requires pure skill and slot machine require pure chance.

It seems apparent that the chance factor is the dividing line between gambling and non-gambling functions with a consideration. For example, risking $10,000 (i.e. the consideration) in a joint-venture (JV) project is not gambling because the outcome of the JV is based on knowledge and market skills. The person can steer his business towards success in many ways; improving efficiency, seeking cheaper source of supplies, cutting unnecessary overheads, creative marketing and exploring new markets. In other words, he has some control over the business. He is taking part in the business itself. He is not a spectator. He is a player. He rides the horse.

In a lottery, a bet is made on an event that he has practically no role to play in determining the outcome of the betting game. He is a spectator and relies on pure chance to win or lose.

Likewise, in commodity trading, a trader buys a forward contract at a stated price but has no control or role in determining the market price (i.e. actual price) at expiry date. At expiry date, if the strike price is lower than the actual price, he makes big money. He is only a spectator to the event.

The same applies to stock futures and options. The person buys the future indexes at a strike price of which the business outcome (i.e. gains and losses from sale and purchase of contracts) is based on the actual index at expiry date. Whether the actual index is higher or lower than the strike price (i.e. index) is beyond his ability to control. It’s like making a bet in horse-race. The trader is the spectator. He is not the guy who rides the horse!

Wednesday, August 10, 2005

Time Value of Money and Murabahah/BBA profits

In conventional loans, the contractual interest rate is the sum of

· interest rate of deposits
· overhead/transaction cost
· inflation premium
· default risk premium

In the case of al-bai-bithamain ajil (BBA) facility, the Shariah can only recognize the overhead and profit margin elements. Both usually only command about 2% and 1% respectively. For smaller banks, the lack of scale economies may see higher overhead cost than larger size banks. Overall, the mark-up element should amount to about 3%.

However, banks must also impute the cost of deposit factor. Since, no promise to pay hibah and mudarabah profits is given, this naturally implies that Islamic banks need not worry about determining the contractual rate of return to depositors. But how can this be if they can declare upfront how much profit they want from each of the murabahah and BBA sale made?

For example, the bank sells an asset for $200,00 on BBA credit term. Accordingly, the BBA or murabahah contract gave customers the right to know the cost price. It is then not difficult to see that given the terms of maturity of say, 20 years, the profit rate per annum should amount to 10% with a nominal mark-up of $100,000.

But now, the question is how should the bank explain the $100,000 profit they make from the BBA sale as legitimate (halal)? Recall the ‘iwad or equivalent contervalue is the condition for a lawful sale. Any increase, according to the majority of jurists in the Shafi’, Hanafi, Maliki, and Hanbali schools must contain ‘iwad.

To benefit from these increases, Islamic banks must be able to provide something of equal value in return. Hence, when someone pays $200,000 on BBA financing at $100,000 cost price, what is the nature of ‘iwad he receives from the bank in exchange for the $100,000 profit?

Certainly, if the transaction is made on the spot or cash basis, problem on the nature of lawful and unlawful gains should not have risen since no time element is involved here. Which means that the bank purchases the goods at direct or wholesale price, it assumes the risk of ownership. While doing so, the bank sells the goods to the customer for $200,000 on cash term.

The legitimacy of the profit made is irrelevant since the bank has indeed delivered the ‘iwad equivalence. This shall be in the form of:

· its ability to make the goods available in the market
· absorbing market risks and risk of ownership (daman milkiyah).

In the former, we are looking at the valued-addition( kasb) factor, while latter describes the ghorm or risk-taking aspects of sale.

However in the BBA sale, it seems that the $100,000 profit is created on the basis of time factor alone. To some extent, we failed to understand how a profit rate of 10% can be determined ex ente when concurrently Islamic banks cannot declare ex ente the rates of return on deposits.

Even if we accept the assumption that the 10% profit per annum charged on every BBA sales arises from 1) cost of deposits, say 3% 2) overhead 2% and 3) inflation premium margin 1%, what then explain the additional 4% stipulated in the contract.

In conventional loans, the 4% can easily be explained by credit or default premium.. This risk premium or spread will vary according to the type and maturity of loans coupled with the credit ratings of borrowers. Normally, bank will charge higher spread when risk of defaults is higher. But these can only hold for loans (qard) and not sale (al-bay’)?

So, what can indeed explain these extra profits that Islamic banks took from BBA sales. If the answer is about risk of default, then certainly it is not about ‘iwad. The risk of default is about the game of waiting for payments and problem of collections. It does not concern market risk. It may be easy to say that profit from BBA is halal since BBA is a not a loan but a sale (al-bay’).

But one has been misled to think that BBA is a spot sale. The mark-up from spot sale is lawful since it contains ‘iwad but can we imply the same for BBA credit sale when no tendency of ‘iwad can be detected there ? This is true since the profit created from BBA is a consequence of waiting i.e. time value. In this sense, the Shariah advisors seemed to have approved gains arising from time value via BBA financing.

Sunday, July 31, 2005

Islamic Economics and Kalam (Theology)

It can take our breath away to see how theology (kalam) matters in Islamic economics. Economics as a study of choice can find deeper enrichment when it takes kalam on board to examine what really choice can mean in Islamic economics.

As I have mentioned in my first essay that Islam sees no harm about the concept scarcity. Scarcity requires man to make choices but to do so requires knowledge.

Muslim scholars who writes about Islamic economics agreed in principle, that the knowledge one applies in making choices is primarily derived from revelation (wahy). For example, what people want may requires us to ask on what basis people prefer goods X to goods Y. On this, reason can provide answers.

But reason may not easily explain why is alcohol beverages not found in the basket of goods of the Islamic economy? Or why the alcoholic drinks considered bads and not goods. The answer is that Allah swt prohibits the consumption of liqour and reason helps explain that what God has said is true indeed.

But it is interesting to find out how this (i.e. choices based on revelation) has become the fundamental principle in Islamic economics. To explore further, theology (‘ilm kalam) provides an interesting explanation.

According to ahlul sunnah jamaah (i.e. the Islamic orthodoxy) value derived from revelation is superior to value derived from reason. But there is no conflict between revelation and reason. In this manner, Islamic economics has subscribed to ahlul sunnah jamaah in matters of espitomology. But the question is why God has given man reason (‘aql) if revelation is the one man must obey? What is role of reason? Can reason determines what is good and what is evil? Can one discover the Truth by way of reason?

For example, the Quran says that riba is haram. Can reason say the same thing? Honesty is a good value i.e. nobody of a right mind would cherish dishonesty. But do we need the Quran to say that honesty is good? Isn’t reason good enough to imply the same? Can reason explain that God exists? Or do we need the Quran to prove that God exists? These are the questions that theologians have answers.

In theology, two group of people, namely the Mu’tazilites and the ‘Asaharites hold contrasting views about the above questions. These are explained the following:

1) The Jabarite school of theology:: They say that man’s actions are determined and predestined by God. Man has no will of his own. He could do nothing on his own choice. Jabarites thinking is also called determinism. Good and evil are all God’s own making.. Believing in the jabarites doctrine will make an individual docile and living without hope of improving his life as everything has been decreed by God. In this manner, the jabarites are also known as the fatalist The Mutazilites protested against this belief by saying that God has given man complete power over his actions as he is free to act any way he liked. It was this freedom of choice between good and evil that man responsible for his deeds. They also say that is man’s actions were predestined, why should God exhort man in the Quran to acquire virtue. Thus determinism of man’s action is not line with the Quranic teaching.

2) The Mu’tazilites school of theology: they are guided by reason and says that man has absolute freedom of will. Man has the power to build his own character, whether to lead a virtuous or vicious life. They maintained that human reason was competent to know the verities of the universe and was completely free to go searching after the Truth. They applied reason to all truths contained in the Quran and explained away those passages that they did not find conforming to reason. They even speculate about the duty of a believer in that if he is incapable of knowing truth by reason, they would be doomed to the hell fire.

2) The ‘Asharite shool of theology: ‘Asharism is a movement that ran counter the ideas of Mu’tazilism. It aims at compromising between reason and revelation. It wants to reconcile the dictates of reason with the dogma of faith. The ‘Asharites gave authority to God and advocates the view of predestination and predetermination of man’s past activities. Man has no freedom of will, no liberty of action but has been given the power of acquisition

One good example to see the doctrinal differences of the Mu’tazila and ‘Asharites is one concerning God, namely:

1. The existence of God
2. The obligation to worship God

The Mu’tazila argued that reason can prove the existence of God. But ‘Asharites then asked: can reason lead people to worship God? Can reason make it obligatory for man to worship God? According to the ‘Asharites, only through revelation that man will oblige to worship God. Reason is inadequate to do so.

Based on the above discussion, understanding the conception of choice in Islamic economcis will require students to examine in greater detail the study of Islamic theology (‘ilm kalam). It tends to show that Islamic economics is no longer merely fiqh oriented but demand an intimate knowledge of theology as well as philosophy to further enrich the discipline.

Wednesday, July 27, 2005

By the Token of Time "Wal 'Asr"

The Quran says, "by the token of Time, man is at loss (khusran) except those who:
1. have faith (iman)
2. do good deeds ('amal salih)
3. strive for the truth (haq)
4. act in patience while striving for the truth (sabr)

One may ask, why Time is put forth by Allah s.a.w. as the backdrop in defining people who are not lost but guided (i.e. those who posses the 4 attributes in the above).

A lot can be said about the meaning and importance of Time and but I can only examine one meaning and that is from the economic prspective.

In economics, we can say that time is scarce. Under that notion of scarcity, time has value. But man can choose to live in leisure and earn nothing. He can also wisely spend the time to work in order to earn money. Man is given the freedom to choose. For that he must be ready to face the consequences of his action. This is a law in nature that no rational person will frown at.

The time factor also shows that people can choose to spend today or postpone their spending to some future date. Choosing the former certainly mean securing the pleasure of spending without delay. People who have work hard to earn money will now enjoy the fruits of their labor today. i.e. attaining happiness and pleasure derived from current purchases.

However, those who chooses to postpone their current spending will have a no definite idea how much pleasure they can secure from future purchases. This is called spending under uncertaintly.

The interest system i.e. riba actually came into being to guarantee certainty. It came to put the law in nature upside down. By paying interest on loans to those who postpone current spending i.e. creditors, the interest system guarantees identical pleasures to that when one chooses to consume today. In this way, people who take and receive riba are indeed those who are in loss (khusran) in a sense that they work against the law in nature.

Investment in Islam operates under uncertainty (i.e. unknown business outcome) as no one but only God knows the outcome of business. If a scheme guarantees certainty on the return of investments, it is none other than the devil. The Quran says, "They who swallow down usury, shall rise in the resurrection only as he aristh whom Satan hath infected by his touch"

Sunday, July 24, 2005

Making loan (qard) is not the way to make profits

Surah al-Baqarah 275 says that, "Allah has allowed al-bay and prohibits riba". The question now is to whom this verse pointed at?The answer lies in the verse preceding the above according to which the disbelievers (i.e. musyrikun) says, " that al-bay is the same as riba".

Apparently, the Quran is putting one point very straight to the musyrikun. If you have money and intends to earn from the money, do it by way of trading (al-bay') and not by making loans and charging riba on them.

The rich merchants of Mekkah (i.e the musyrikun) who relentlessly stood against the teaching of Prophet Muhammad (saw) usually make money from loans (qard) in two ways:
1) making loans to the poor sorely for their consumption needs
2) making loans to traders as capital

Making loans with riba to the poor often exploits them. Defauting borrowers eventually becomes slaves to the lending party. For this reason, the Quran prohibits riba as it is unfair. Riba opens the doors to exploitation.

The rich people of Mekah also provide riba loans to the merchants and traders. Artisans may borrow to purchase raw materials. The traders involved in caravans trading resorted to riba loans, while others opted to trade by way of mudarabah. The former must return the capital and riba upon arrival in Mekah. If they fail to do so, the implication has been disastrous.

The caravan trade is highly dangerous and risky. It involves long-journey travels through severe heat of the day and cold in the nights. Highway robberies and desert storms are the norms. Equally important, caravan traders are also exposed to market volatilities. There is no guarantees that goods can be sold at profits.

For example, a caravan merchant buys X for 5 dinar in Mekkah and sells it for 10 dinar in Syria. While in Syria he purchases Y for 10 dinar and sells it in Mekkah for 20 dinar. In this way his total profit is 20 dinar - 5 dinar = 15 dinar while the ROI = 15/5 x 100 = 300%. But this is true only when he reached Mekkah alive and well as the journey took him more than 1000 miles across the desert. He will see the creditor and pays back the 5 dinar loans plus the riba.

However when he failed to sell X due to unforseable reasons, say losing market or destruction of goods during the caravan travels, he end up defaulting the loan. For this reason, when traders seek to use riba loans to finance their travelling expenses (say, from Mekah to Damascus) as well as purchases in Mekah, failure to earn profits always means a failure to pay up the loans and riba attached to the loans. That failure as mentioned earlier always leads to disaster. The rich lenders will confiscate properties belonging to the traders or turn them in slaves when nothing is found enough to replace the loans.

The same does not apply in the mudarabah system. The mudarabah is the financing aspects of the whole business of caravan trading. The main line of transactions remains to be buying and selling of goods and commodities where payments are settled on the spot. It does not make sense, to see the Prophet Muhammad (saw) having purchased an item worth 4 dinar in Mekkah offers the same for 10 dinar cash or 14 dinar on credit in Damascus. Certainly, the sale is settled on the spot in Damascus at 10 dinar!

The mudarabah system is an egalitarian one. If the business does not go well, the capital provider shall bear the loss. The agent-entreprenuer (i.e. mudarib) is spared from all liabilities except those incurred by way of negligence.

The caravan trading actually illustrates the nature of risk that people always face in that business. It is by no means to bring us back to the old ways. The risks are severe as in any modern business today. Some examples are price and operational risks.

To sum up. to earn money one must stay away from lending. Lending money to consumers and producers often invites injurious relationship. Of course, when lenders dutifully pay up their debts, riba is beneficial but the reverse has always mean injury and hardship to the borrowing party.