Saturday, 11 May 2013

Alternative Paradigm to Financialization : How Finance works in a non-Banking World

Alternative Paradigm to Financialization : How Finance works in a non-Banking World
Finance in a non-Banking World


The world financial system came into global focus in the aftermath of the 2008 financial crisis that saw companies such as Lehman Brothers, Bear Stearns and AIG effectively collapse under the liabilities that they had amassed.

Many questions were raised but as has happened before, such as during the depression of the 1930’s, the story we were told was that the failing was due to the degree of over sight by the regulators as opposed to being due to the core idea of the capitalist economic model itself. Therefore no root level scrutiny was ever undertaken as the core ideals of capitalist markets are taken as self evident truths and the key point for us is that the capitalist manner of achieving these self evident truths are also taken as if there is no realistic alternative in the modern age.

This is however now being questioned and the debate is shifting with the help of ground breaking books such as “Capital in the Twenty-First Century” by a French economist called Thomas Piketty which attributes the wealth inequality to the Capitalist model itself and not to its improper implementation as is the current mainstream narrative.

This paper focuses on the financial market element of the capitalist system and attempts to show that it leads to wealth inequality rather than as advertised to serve the requirements of genuine entrepreneurs in creating wealth for all. The paper also seeks to differentiate between the valid aims of the current financial system and those goals which are conducive to generating market instability and great wealth disparity.

The paper will then present alternative approaches to achieve the valid aims that are sought under Capitalism. Not everything upheld within Capitalism is rejected. There are some self evident truths that are equally acknowledged and promoted in the Islamic Economic System. The key one being the benefit of the benefit of specialization or 'division of labour'. The paper will also identify the erroneous aims of the financial markets, and bear in mind that such aims are not in need of an alternative approach within the Islamic Economic model.

Debt vs. Equity Financing

The first area of comparison (and one which is a valid aim) is related to capital allocation or the role of financial markets in bringing capital into contact with business entrepreneurs to generate wealth. This is currently done to a large degree via the interest based debt model in the Capitalist system were owners of capital can loan their financial assets to people wanting to undertake business activity.

In the Islamic Economic System (henceforth referred to as IES) the finance model is based on Equity finance as opposed to interest based debt finance. In this context, equity refers to funds available from savings as opposed to funds borrowed from banks on interest.

The way equity finance works is capital partners ie people with money  typically from savings, enter into partnership with other capital partners or partners who bring the entrepreneurial aspect alone to the partnership and engage in a risk and reward sharing contract.

A number of distinct company structures exist, such as Mudharaba, Al-‘Inan, Al-Abdan etc, to cater for the various combinations of capital and entrepreneurial partnership roles but the essential principles are the same. These are all of the Musharakah structure.

In all such structures, profit is shared according to a ratio (pre agreed between partners) and the losses are in proportion to the capital share of the partner. There is no concept of limiting the liability of the partner. In the case of the body partner, that is the partner who only inputs enterprise without any capital, the loss is only upon the effort exerted as there was no capital investment by that partner. The company is thus formed of partners not their capital, unlike Capitalist companies where the corporate entity is formed of the capital contributions of the investors.

The Prophet Muhammed SAW said

“The loss (Al-Wadhi’a) is upon the capital and the profit is according to what they stipulated.”

Incentives for Equity Finance

The question arises of what incentive may exist to bring capital into such arrangements unlike the incentive to loan money on interest or loan equity without risk to personal assets. To understand this question, one needs to consider other rules and realities in the IES, which discourage the hoarding of wealth and this ensures funds find their way to new and creative business ideas creating an environment ripe for business investment and consequently employment and wealth distribution.

These rules include the following:-

·                   Zakat, a tax levied on unused wealth at the rate of 2.5% payable annually.
·                   Prohibition of hoarding the medium of exchange (money) which provides a religious obligation to use         
the money in a productive manner. Hoarding is this context refers to storing money with no aim or
objective. This is contrary to saving money for a project or specified aim with a timescale.
·                   Lack of interest bearing bank accounts or any other interest based investment vehicle, which motivates
other creative forms of money investment.

How do large scale industries cope without public equity market availability?

As the Islamic company structures are formed of partnership and agreement between partners as opposed to their capital. This is a natural limiting factor to how large the Islamic structures can scale as partners may be wary of the potential liabilities that may be incurred. They are also dissolved and reformed when partners leave which may limit the practicality of having partners with hundreds of partners. However they can grow as large as the capital and body partners are prepared to accept and methods such as online agreements are plausible to bring together agreeing parties.

In the joint stock PLC structure, shareholders do not contract with each other, instead their share capital contracts with the capital of other investors and this enables them to grow to a significant scale as no inter-partner agreement is involved as to who can and cannot be included in the ownership of the company entity.

This contrasts as mentioned, with the Islamic model were partners need to engage on offer and acceptance amongst each other as the company is formed of their person and not their properties.

The question of how natural monopolies or industries such as oil and gas exploration would survive in an environment without conventional stock markets arises. Such industries often have huge start-up costs that need thousands of investors pooling their capital to make such projects viable.

In the IES, there is a separation between private property, public property and state property and such projects fall within the purview of public and property. Public property is owned by the public at large but managed by the Islamic Government which levies a charge for the supply and maintenance of such industries. Therefore the pooling of funds still occurs via the pooling of fees and in this case for the provision of a service as opposed to for the profit motive.

How effective will Equity Finance be ?

There will be far greater disposable income and savings in the IES, due to a number of factors too plentiful to list but as an insight one can consider the following:

The monetary unit is the gold and silver currency which will cause a stable to mild deflationary environment which will ensure incomes can easily keep pace with prices unlike the scenario we see with monetary inflation eating into the disposable income of families. Unlike in the 1950’s through 1970s, both partners often now need to work to maintain the standard of living that the previous generation enjoyed with only the male working.

The fact that the taxpayer today is paying more and more for bailouts that the casino behaviour of the financial markets caused in the 2008 crisis and ongoing sovereign debt crisis in Europe, is another reason why we are so impoverished that most people have no savings and rely on borrowing on interest. Compounding this impoverishment is the right afforded to banks to ‘print money from thin air’ and then loan such money back to the government on interest paid back by the taxpayer! Surely it would be less impoverishing on the common man for the government to be allowed to print the money to avoid the interest payments back to the banking establishment, an idea sought by Abraham Lincoln when he devised the green back monetary unit. So the focus should be on the systemic impoverishment under Capitalism and not why the IES does not have such loan facilities.

note: Both approaches are rejected in the IES, were money must be fully backed by Gold & Silver.

Finally, unemployment will be lower as smaller companies create more price competition and greater innovation which in turn creates jobs which translates to wealth and savings for all and this means a higher pool of investable funds to fund novel business ideas. This contrasts with the mass consolidation of business and the relative death of the SME sector which is key for job creation. This wealth concentration and job destruction has been occurring by stealth in the Capitalist model were many brands, which cunningly maintain their original brand names to create the illusion of competition are in fact owned by fewer and fewer organizations.

Why is there such a reliance on loan based finance in the Capitalist System?

The previous paragraph goes some way to answer this but let us probe this further.

Due to some fundamental traits that are systemic to the way Capitalism works, based on its fundamental utilitarian view, powerful entities come to dominate weaker entities within the free market system and the political class is not exempt from this.

Nowhere is this more painful than in the system which governs the supply and control of money itself.

Money, due to the covert power and subversive influence of the global banking establishment over the last few hundred years  has come to reign over the system that issues currency through the adoption of the central bank model of banking. In the UK this institution is known as the Bank of England and in the US it is known as the Federal Reserve or the FED for short.

The way these private institutions work as far as the issuance of currency is concerned leads to mass impoverishment as money is created out of virtually thin air and lent to the government on interest and paid back through taxation. So the Banks are able to take the real wealth that hard working members of society create and give back money that was created through the action of entering digits into a computer. It is of no surprise that wealth has flowed from the real economy to the virtual financial economy since this monetary system was accelerated towards this system since the demise of the gold standard.

Under the Gold standard, this would not be possible as there would be a natural anchor to the issuance of currency that would limit such powers.

So in conclusion to this point, the prevalence of such high taxation, amongst other things, keeps the  majority of the population below the level of wealth that they would otherwise reach, and as such savings are in decline and the reliance on loans are on the rise relative to what should be expected had society been free of the dictates of the global system of central banking. This cannot be said for the IES and as such we can be confident that equity finance will be an effective alternative to the debt based financial approach of capitalism.

How are other aims of the Financial Sector realized under the IES

What about other functions of the financial sector that are projected as being vital for effective market participation and without which wealth to the scale seen in the west is supposedly unobtainable?

These functions include hedging, price discovery for various financial products including exchange rates by conducting trades through regulated exchanges and the clearing of trades through large entities (called clearing houses) that act as financial intermediaries to buyers and sellers which reduces the risk of the other party defaulting and thus encourages trade?

It is true that such functions encourage trade that would not have otherwise occurred. Such products are non-existent in the IES, so is this not a weakness of the IES one may ask?

Hedging or limiting exposure to risk:

The exposure that is supposedly mitigated through various products, called derivatives, such as Credit Default Swaps, is exposure that is largely created by the idiosyncrasies of the Capitalist system itself and not exposure that is universal to private sector markets.

To substantiate this, consider the following realities that are endemic to the Capitalist version of the private sector:-

·     Business cycles that cause cyclical upturns and downturns in markets due to the abundance of cheap credit (FIAT currency coupled with artificially maintained low interest rates by central banks) and assets bubbles which have economy wide repercussions when prices ‘crash down’ to market fundamentals.

·     Weak demand due to weak confidence, which is based on irrational fears. This phenomenon was referred to by Keynes as ‘animal spirits’ and has also been called the ‘paradox of thrift’ in the literature.

President Franklin D. Roosevelt summed this phenomenon well when he said:

“the only thing we have to fear is fear itself!”

This fickle and temperamental  nature is not prevalent in the IES due to different fundamental concepts held by adherents of the Islamic belief, such as the concept of Rizq (God provided all provisions but we are obliged to seek it) which make market participants more robust and confident and not prone to such irrational herding behaviour that brings instability to markets.

·        Gold and Silver based currency which avoids exchange rate unpredictability removing the need for derivative products that compensate for wild fluctuations in fiat currency based exchange rates.

Furthermore, the idea that risk can be completely mitigated through such products known as derivatives is a complete misnomer and what really happens is that risk mitigation at the scale of individual trades is building up systemic risk which causes instability in the entire system. This is a realization from the prior position, proposed in the 1990’s of the idea of complete risk elimination via such financial products, an idea embodied in the Black-Sholes model which was manifested in the business model of Long Term Capital Management (LTCM). The idea that risk could be eliminated completely was proven to be false when LTCM failed within 4 years of its adoption of this assumption. The recent credit crisis of 2008 is thus the second climb down from this position with the view now being that even partial risk elimination is at a cost of systemic risk. This would explain why Warren Buffet described derivatives as “weapons of mass destruction”.

Furthermore, the notional value of the derivative industry dwarfs the size of the real economy by a factor of 20, which proves that it is not in line with hedging risk and paradoxically, such products actually increase the risk of the underlying asset defaulting! This is due to the higher price of such insurance protection raising the market perception of default leading to selling in large quantities which can crash the price of the underlying asset that protection was sought for by those who took protection for genuine hedging purposes.

As far as the price discovery function of financial markets for products traded over exchanges, this is not a handicap in the IES as the products that are traded in the financial markets and in need of such complex pricing models, for example derivatives and stocks or equities are not traded so we do not need to tick this box.

However foreign currencies are traded on the international markets (known as the FOREX market) and traders in the IES can obtain foreign currency when importing goods at the spot rate as this has been permitted by the Sharia rules, so the lack of a currency market within the IES will not present issues as far as establishing a fair price for currencies needed by traders within the IES when importing goods. It should be noted that only around 3% of all currency trading is relating to import and export requirements according to the Bank of International Settlements.

As far as the clearing house function, what happens in conventional markets is that traders, who often do not trust each other trade with what is known as a central counter party (CCP); so trader A sells to the CCP which in turn sells onto trade B. Ultimately trader A wished to sell to trader B but lacked confidence in trader B unlike the case with the CCP. This gives financial institutions such as investment banks a key role in facilitating trade and a criticism of the IES could be leveled that without CCP’s the volume of such trade would be impacted.

What such critics fail to factor in is that such large trade volumes are usually composed of over blown financial products which are by their nature prone to the risk of default. 

Also the Islamic ethos in the IES for honoring contracts and rights coupled with having sufficient collateral and no limitation of liability reduces the likelihood of wild speculative behavior which eliminates the need for such trade guarantees. Therefore such solutions are a fix for a problem made by the capitalist system and not a performance indicator for the IES.

Finally, it is often argued that the financial markets have managed to quell the excesses of the boom and bust cycle or business cycle through various means such as via the control of the money supply via interest rate manipulation. This may be used to criticize the IES as such a lever, does not exist as a policy option.

The problem with this argument is that it presupposes that the business cycle is an inherent feature of private market activity. However this is far from accurate and the more accurate explanation is that the business cycle is a consequence of the interest based FIAT monetary system as cheap money by artificially created interest rates fuels false booms which burst when interest rates rise and the mal investments are liquidated.

So this is not a valid criticism of the IES and another plaster for a cut that the IES doesn’t suffer from.

What role, if any, will Banks have in the Islamic Economic System

In the IES, conventional retail banks would not exist as there is neither fractional reserve banking that allows for money to be created from nothing, nor interest based lending.

However a bank function could be in helping capital partners meet and form partnerships structures. This is similar to one of the functions of investment banks which are involved with mergers and acquisitions helping companies grow into new larger entities however the scale of the companies will be considerably smaller than the capitalist PLC structures as mentioned above.

Also, there may be a role for them in providing a clearing mechanism to enable people to use credit cards and cheques instead of notes, which themselves are used instead of carrying physical gold and silver. This system (Sakk system) was in fact in use since the time of the Khalif Harun al-Rashid in the 9th Century so would not be a novelty in the IES. However some of these functions could also be undertaken by the state treasury (Bait-ul-Maal).


The myth we are sold is that the financial sector, despite its recent ills, is vital to provide credit which is the lynchpin of growth and wealth creation. The financial sector is thus depicted as the facilitator of the real economy which is where real wealth is created. However the reality is quite the opposite. It has grown disproportionately large; ingesting the loss of jobs from the real economy and replacing those for parasite financial sector jobs and it is now is attacking the real economy through the financial burden that has been placed on each and every taxpayer.

The alternative must be brought to the fore of the debate so that the myth is dispelled and the masses are liberated from the financial sector octopus which through its tentacles is drawing real wealth from the efforts of the common man into the hands of the global bankers and financial elites. With mainstream attacks such as Piketty’s book now starting to unravel the historical fig leaf used to defend capitalism, the opportunity has never been so potent.

1 comment:

  1. Thank you for your article. I'm afraid a still a bit confused about the link between the financial and real economies. For example, I'm finding it hard to exemplify the following paragraph and was hoping you could explain it further:

    'Furthermore, the notional value of the derivative industry dwarfs the size of the real economy by a factor of 20, which proves that it is not in line with hedging risk and paradoxically, such products actually increase the risk of the underlying asset defaulting! This is due to the higher price of such insurance protection raising the market perception of default leading to selling in large quantities which can crash the price of the underlying asset that protection was sought for by those who took protection for genuine hedging purposes.'

    Are we saying that, for example, a derivative related to coffee decreases the stability of the coffee market and, if so, how? Jzk