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2016 | Book

Islamic Finance in the Light of Modern Economic Theory

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About this book

This book provides researchers and students with an understanding of the basic legal tenets of the Islamic finance industry, studying the real economic effects of those tenets using the tools of the modern economic theory. Split into four parts, the book begins with an introduction to the history and a legal framework for Islamic banking, covering typical Islamic financial products such as Sukuk and Takaful and examining the structure of Islamic financial institutions. It then analyzes and discusses the Miller-Modigliani Theorem, which is of direct relevance to Islamic banks which are prohibited to charge interest and often have to rely of profit-loss sharing agreements. Part III of the book introduces the reader to modern mechanism design theory, paying particular attention to optimal contracting under hidden action and hidden information, and final part of the book applies the tools of economic theory to understand performance of Islamic financial institutions such as Islamic banks and Takaful operators.

Islamic Finance in Light of Modern Economic Theory brings together all the necessary technical tools for analyzing the economic effects of Islamic frameworks and can be used as an advanced textbook for graduate students who wish to specialize in the area, as a reference for researchers and as a tool to help economists improve the design of Islamic financial institutions.

Table of Contents

Frontmatter

Islamic Finance: Rationale, History, Instruments and the Legal Framework

Frontmatter
1. Introduction
In this chapter we discuss our main rationale for writing this book and introduce the reader to the two worlds of finance.
Suren Basov, Ishaq Bhatti
2. Islamic Financial Instruments
In this chapter we are going to describe the major Islamic financial instruments and compare them with the conventional ones. Islamic financial instruments can be divided into equity-based and debt-based instruments. The first group includes mushārakah, a contract governing the pooling of labor and capital, and mudārabah, an agency contract. The second group consists of murābahah, a generic sale contract, salam, which allows the seller not to be in possession of the good at the time of sale; however, the good must be fungible and readily available on the market, istisnā’, which is similar to salam, but dispenses with the fungibility requirement, and ijarah, which refers to renting someone’s goods or services.
Suren Basov, Ishaq Bhatti
3. The Historical Roots and Evolution of Islamic Financial Thought
Islamic banking is a modern phenomenon; however, its roots go deep into history with its principles primarily derived from the Quran. An early market economy developed in the Islamic world between the eighth and twelfth centuries, which was based on an early form of mercantilism, sometimes called Islamic capitalism.
Suren Basov, Ishaq Bhatti

The Law of Unexpected Consequences

Frontmatter
4. The Incidence of Taxation
In this chapter we consider a situation where a government levies a tax on the producer or on the consumer of the good. We show that, contrary to what one might guess, the economic burden of taxation, known in economics as tax incidence, does not depend on where the tax is levied, but on the price elasticity of demand and supply.
Suren Basov, Ishaq Bhatti
5. The Basics of Corporate Finance: The Miller–Modigliani Theorem
The previous chapter illustrated that our intuition is not a very reliable guide when it comes to designing complex policies and that formal analysis is often needed. The issue of tax burden, though important, is of no direct relevance to the theory and practice of Islamic finance (IF). The example we consider in this chapter, how the value of the firm is affected by the way it is financed, is of direct relevance to IF. When you decide to start a business, one of your first questions is likely to be how to raise the money to finance your operations. Broadly, there are two ways to raise funds: taking debt or issuing equity. Debt financing, however, requires one to pay interest to the lender, typically a bank. Islamic law prohibits charging interest or entering into a contract that requires one to pay interest. Is such a requirement a significant handicap for Islamic businesses?
Suren Basov, Ishaq Bhatti

Game Theory and Mechanism Design

Frontmatter
6. Game Theory
In this chapter we will start by defining the concept of a game, before defining that of Nash equilibrium and evolutionary game theory.To describe a game in general one has to specify: the players, that is who is involved; the rules, that is who moves when, what they know when they move, what they can do; the outcomes, that is for each possible set of actions, what will happen and what the payoffs are.
Suren Basov, Ishaq Bhatti
7. The Revelation Principle
The main application of game theory to IF comes through a technique known as mechanism design. In a mechanism design problem a designer, a principal, (a seller of a good, a government, a board of directors, etc.) tries to design an economic mechanism (a pricing schedule, a tax code, an employment contract, etc.) to achieve a certain social or economic objective.
Suren Basov, Ishaq Bhatti
8. Monopolistic Screening
In this chapter we look at the monopolistic screening model, which is a particular example of the non-linear pricing model. Non-linear tariffs include railroad and electricity schedules and rental rates for durable goods and space. Another application of these models is to devise an optimal compensation scheme for a firm’s manager. The major justification for non-linear pricing is the existence of private information on the side of consumers.
Suren Basov, Ishaq Bhatti
9. The Multidimensional Screening Model
In this chapter we will discuss the multidimensional screening problem, that is the problem that occurs when the private information of the consumer cannot be captured in one characteristic. The general formulation of this problem is provided by Armstrong (1996) and Wilson (1993), and goes as follows. Consider a multiproduct monopoly producing n goods (or a good with n quality dimensions) with a convex cost function.
Suren Basov, Ishaq Bhatti

Mechanism Design Applications to Islamic Finance

Frontmatter
10. Business Loans, Trust, and Contract Restriction Faced by Islamic Banks
In this chapter we consider the effect of social norms on economic performance, using an example of an Islamic bank providing a business loan to an entrepreneur. We show that the ability to rely on a social norm mitigates the moral hazard problem, but introduces rigidities that prevent an optimal response to adverse economic consequences, thereby improving performance during booms, but handicapping it during recessions.
Suren Basov, Ishaq Bhatti
11. Loans Provision and Adverse Selection Within Orthodox Religious Communities
In this chapter we investigate the wisdom of restricting business loans to the members of a club, which can be interpreted as a community united along social, cultural or religious principles. Members of the club can be more trustworthy, which will help to mitigate moral hazard problems, but may also possess lower levels of human capital. If human capital is imperfectly observable, this will create an adverse selection problem. We discuss this trade-off, developing a multidimensional screening model of loan provision. As a particular application of the general model we consider business loans provision by Islamic banks.
Suren Basov, Ishaq Bhatti
12. Shariah Compliance and Risk-Incentive Trade-Offs
In this chapter we are going to consider the principal–agent relationship. We will start by reminding the reader of the results of the conventional principal–agent problem, then consider it under a mudārabah contract, before finally discussing how social norms can be used to mitigate the risk-incentive trade-offs.
Suren Basov, Ishaq Bhatti
13. Shariah Compliance, Positive Assortative Matching and the Performance of IFI’s
Recently, Derigs and Marzban (2009) considered the effects of different strategies for constructing a shariah-compatible financial portfolio. They argued that shariah-compliant strategies result in a much lower portfolio performance than conventional strategies, because such compliance limits the set of admissible investments. Shariah finance does indeed prohibit investment in certain assets and industries, such as conventional bonds, derivatives, armaments, sex, tobacco and the gambling industries. However, the effects of these prohibitions are not exclusively negative. For example, a firm that is run in the interest of shareholders, protected by limited liability, is prone to excessive risk taking. If excessively risky projects are more likely to occur in these industries, the commitment of Islamic banks not to invest, enforced by shariah advisory boards, may result in an improvement of financial performance and attract more debt financing. Debt financing may also prove to be more beneficial than equity financing from the point of view of providing better incentives to management. This means that the effects of limiting the set of admissible investments by shariah law is ambiguous and invites us to seek for an alternative explanation of the low performance of Islamic banks. Let us briefly consider the costs and benefits of asset restriction.
Suren Basov, Ishaq Bhatti
14. Optimal Incentives for Takaful Operators
In this chapter we are going to discuss the structure of the optimal incentives for takaful (Islamic insurance) operators (TOs). This is based on a recently published paper by Khan (2015). As emphasized by Khan, the main difference between conventional and Islamic insurance, relevant to the structure of optimal incentives, is that, while the conventional insurance contract is a contract of risk transfer, the Islamic insurance contract is one of risk-sharing.
Suren Basov, Ishaq Bhatti
15. Can Short-Selling Prohibition Be Optimal?
In the first chapter of this book we listed ten conditions a sale contract should satisfy to be legitimate under Islamic law. In particular, we argued that these conditions prevent short-selling. The reason for this is mainly historical. If legal institutions are not properly developed, short-selling can invite cheating by collecting the fee and not delivering the good or the asset. In modern financial markets the ability to short-sell assets is believed to undermine efficient risk-sharing. Most asset pricing models, for example the Fama-French model, CAPM (capital asset pricing model), APT (arbitrage pricing theory) and their variations, assume that the traders are able to short sell their assets.
Suren Basov, Ishaq Bhatti
16. Conclusions
In this book we have described the historical roots of Islamic financial Institutions (IFIs), the objectives they try to achieve and the formal framework developed, which allowed us to analyze whether they do in fact achieve their stated goals. We found that often the good intentions of Islamic banks and other institutions are frustrated by the law of unintended consequences. Usually the law comes into play when bankers, policymakers, religious authorities or other decision-makers fail to take into account the fact that economic actors will adjust their behavior in the light of new policies. In all these examples action of an economic actor goes against the intentinons of the policy maker. The government imposed a tax on a firm to get resources to help consumers, but an unintended result that goes against the government’s intention is the raise of the price of the good, produced by the firm. The bank may be prohibited from sharing losses with enterpreneurs in order to attract more enterpreneurs to business activities, but the banks response, descrease of the premium for success can have exactly the opposite effect. Since inability to share losses is a characteristic feature of Islamic banks, the enterpreneurs who are more likely to succeed may choose not to approach them at all, and approach conventional banks instead.
Suren Basov, Ishaq Bhatti
Backmatter
Metadata
Title
Islamic Finance in the Light of Modern Economic Theory
Authors
Suren Basov
M. Ishaq Bhatti
Copyright Year
2016
Electronic ISBN
978-1-137-28662-8
Print ISBN
978-1-137-28661-1
DOI
https://doi.org/10.1057/978-1-137-28662-8