Issues in Islamic Finance

The analysis presented here argues that the problems afflicting present-day economies arise primarily from the use of interest-based banking. In contrast to the teaching of mainstream economic theory, interest as an incentive for ensuring an efficient allocation of resources simply does not, and cannot, achieve results that are in any way comparable to those that may be achieved when profit is used for the purpose. Significant differences exist between profit and interest as motives for the efficient allocation of capital. These difference have important consequences not just on how resources are allocated, but also on how the rewards of productive activity are distributed.

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Issues in Islamic and Conventional Finance

Interest-free economy

A question of efficiency

The analysis in the preceding chapters shows that resources are allocated efficiently in an interest-free economic system and inefficiently in a system where interest is used as an incentive to reward capital providers for taking part in business enterprise. The reason is that in interest-free financing (risk sharing) the returns to the providers of capital depend on the efficiency of the businesses they finance. As investors are required to share risks with entrepreneurs, rewards to investors (dividends) rise and fall in tandem with profits. The risk facing investors provides a powerful incentive to them to invest in enterprises that have realistic prospects of earning profits. Put differently, risk provides a powerful motive to investors to exercise due diligence and thereby ensure an efficient allocation of resources.

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Chapter V – Interest-free economy

 

Keynesian paradigm

Interest or profit?

Despite evidence to the contrary, mainstream economic theory continues to maintain that interest-based financing allocates resources efficiently. Conventional stabilization policies have met with limited success. The main reason is that they are based on flawed economic analysis, the Keynesian paradigm. A closer look indicates that this theory is deeply flawed. The primary flaw in this model is the assumption that interest is little different from profit as an incentive to ensure an efficient allocation of resources.

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Chapter IV – Keynesian paradigm

Harmful Effects of Interest

Equity or loan financing?

Equity and loan financing impact the economy in different ways. In the case of equity financing these effects are beneficial. By comparison, the effects of interest-based loan financing are invariably harmful. The first adverse effect of loan financing is indebtedness. Additionally, delinking rewards paid to the providers of capital from the profitability of the enterprises receiving financing, a basic feature of loan financing, reduces the efficiency with which resources are allocated throughout the economy. Inefficiency emerges within the economy not only in reduced productivity. It also manifests itself in the form of inflation, unemployment, slow or declining economic growth, instability in the form of business cycles, and an uneven distribution of wealth.

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Issues in Islamic and Conventional Finance – Chapter III

Islamic Finance

Risk sharing or risk transfer?

In Islamic finance investors make funds available to entrepreneurs on the basis of risk sharing rather than by means of contracts that confine all risks of business enterprise to the entrepreneurs. Loan financing, unlike financing on the basis of risk sharing (equity financing), requires borrowers to guarantee not only the periodic payments interest, but also the repayment of the principal amount of the loan. The dates on which payments need to be made, as well as the amount of the payments are specified in advance.

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Issues in Islamic and Conventional Finance – Chapter II

 

 

Issues in Islamic Finance

Replication or innovation?

Islamic finance experienced rapid growth since 2001 until about the 2008 global financial crisis, when a number of sukuk defaulted while others nearly defaulted. A number of issuers were unable to make periodic payments to investors on schedule as promised. When it became clear that not only the periodic payments but even the investors’ capital was at risk, alarm bells rang across the world of Islamic finance.

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Issues in Islamic and Conventional Finance – Chapter I

 

Introduction

Linking effort and reward

A well-regulated economic system requires incentives that reward productive and withhold rewards from unproductive activity. Such incentives are put in place by means of legislation and enforced with the help of regulatory agencies. A well-managed system will allocate resources more efficiently than a system in which income may be gained without active participation in economic activity, by lending at interest in particular, which invariably increases the prices of finished goods without, however, adding any value. Despite many adverse macroeconomic effects of debt financing, lending at interest occupies a prominent place in conventional banking and finance and, to a lesser extent, in Islamic finance, in a replicated form. This should be of concern. What should be of even greater concern, in particular to policymakers in Muslim nations, is that to the extent that Islamic finance replicates mainstream finance, it also replicates the latter’s harmful effects.

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Issues in Islamic and Conventional Finance – Introduction