Islamic Finance
A Distant Mirror
Paul Maidment 04.21.08, 6:00 PM ET



A modern Islamic banker would readily recognize a contractum trinius, a structured, 13th-century financial product designed to circumvent the medieval Catholic Church’s proscription of usury.

It was mostly illegal in Christian medieval Europe to charge interest on a loan of money, for much the same reasons Islamic law forbids it: That, as money is intrinsically unproductive, it is ethically wrong to make money from money. A contractum trinius replicated a fixed-interest loan by combining three simultaneous transactions–an investment by the “lender” in the “borrower,” an insurance contract and a profit-share arrangement for a fee–each acceptable in their own right under cannon law.

The ecclesiastical loophole was that the Church allowed modest “compensation” over and above the amount due on a loan for the hazards and delays of repayment or any legitimate reason providing it was not intrinsic to the contract. The simultaneous contracts could be arranged to replicate any agreed interest rate while providing legal protection against default on one side and loan sharking on the other.

Compare a contractum trinius to a murabaha contract, a structured financial product offered by Islamic banks as a way around the Koran’s proscription of riba, or usury.

Such a contract might be used to finance the purchase of goods thus: The faux buyer would promise his bank to buy the goods from it in the event the bank bought them from the seller. With that promise in hand, the bank would make the purchase and immediately sell it onto the buyer at a mark-up, agreeing the buyer could pay, say, three months after goods are delivered–in effect, trade finance at a fixed rate with legal protection against default on the one side and loan sharking on the other.

A secular economist would see little or no substantive distinction between the sharing of profit, sanctioned by Islamic law, and interest, which is not. Credit has a cost, and under perfect competition, this is the interest rate–the price at which lenders agree to supply the same amount of money that borrowers agree to borrow. Banks don’t determine where that point is; they act only as intermediaries between savers and borrowers.

A non-Islamic bank does this by attracting savings deposits at a particular interest rate. It then lends out these deposits at a higher rate to borrowers; the difference between lending and borrowing rates pays for the banks’ costs, including satisfying its shareholders. Competition between banks will tend to bring the lending and borrowing rates closer together, theoretically squeezing bank profits to zero in the ideal case of a perfectly competitive market.

An Islamic bank cannot offer a fixed interest rate to those who trust their savings to it for safekeeping, but it can give them a gift that acknowledges the time value of money in appreciation for the use of funds by the bank. That gift comes from the return the bank gets on its investments. At equilibrium, all its investments will yield the same expected return, equal to the lending interest rate in non-Islamic banking. Its operating costs, let us assume at this point, will be the same as a non-Islamic bank’s. Since both the price of credit and costs remain the same, profit will also be unchanged.

Under perfect competition, the Islamic bank will have to distribute all profits to depositors or lose them to another bank that does. Under both systems, banks cover their costs, including dividends to shareholders, and then hand over what’s left to depositors. The only difference is whether the price of the credit is expressed as a fraction of profits or as a predetermined interest rate.

One place the economist might see a difference is in the two banks’ business risks, and thus their costs. Islamic banks will face a higher cost of credit because returns from profits are variable: high in good years and low in bad ones. The return on a fixed-interest-rate loan is, well, fixed. To compensate for this, the Islamic bank will have to add an additional charge to each loan that effectively pays to insure it.

The transactional friction that Islamic banks create in structuring financial services to be Sharia-compliant is repeated across all products, whether they are loans, mortgages, bonds or asset-management offerings. This is a charge Islamic banks cannot squeeze out completely no matter how well they run themselves, making their products more expensive–and to an economist’s eye, less efficient–than non-Islamic competitors.

That may not matter to their customers. The higher cost of Sharia-compliant financial products, whether expressed as higher fees or lower returns, is simply the price certain consumers are willing to pay for feeling righteous. Indeed, for some particularly religious Muslims, that price is so high that they won’t use banks at all unless they offer Sharia-compliant products.

In the U.K., HSBC and Islamic Bank of Britain both offer Islamic current accounts and mortgages aimed at Britain’s 2 million Muslims, many of whom do not use established banking services because they are in conflict with Sharia.

It took centuries for usury laws to disappear in Europe. Pope Benedict XIV promulgated an encyclical Vix Pervenit: On Usury and Other Dishonest Profit as late as 1745, and it has yet to be formally retracted. But adherence was fading long before, as the Catholic Church retreated from actively enforcing its social teachings on finance. By the time of the Enlightenment, the provision of credit and the practice of charging interest on loans had already become universally accepted as an issue of political economy rather than theology.

The sea-change in attitude dates back at least to the 1530s, when England’s Henry VIII broke with Rome over the issue of his second wife (out of an eventual six). Free from Rome’s oversight, competition in banking opened up simply by removing the proscription on lending. Prior to the English Reformation, would-be borrowers had had to turn to the much smaller universe of non-Christian (usually Jewish) money lenders.

Restricted supply meant money lenders had monopoly pricing power and could charge borrowers artificially high rates. In medieval Latin, the term usuria was used interchangeably for interest and excessive interest, much like the Arabic word riba is used today.

After Henry legalized interest in 1545, short-term annual interest rates dropped to between 9% and 10% from 20% to 30% and created a clear distinction between usury as predatory lending and interest as legitimate compensation.

Of course, Islamic banking is much more complex than medieval Christian money lending. Not only has banking itself developed into a complex range of financial services, from insurance to home loans, that Islamic banks must synthesize, but Sharia also proscribes involvement in transactions involving alcohol, pork and gambling.

The prohibition on gambling is especially important. Islamic scholars have interpreted it as ruling out activities containing a high degree of uncertainty. That rules out options and derivatives. It also means that Islamic banking needs to be full-reserve banking–Western banks typically loan out a multiple of the amount of money they have on hand, or in reserve. In theory, this is safe, because it is highly unlikely that all the bank’s depositors will demand their money back at the same time. Sharia, however, doesn’t allow for that risk. Muslim banks must keep enough money on hand to pay back all their creditors. This is a major retardant to growth for strictly Islamic banks.

Banking scholars also argue that Islamic law blocked indigenous financial modernization in Muslim countries because of an inheritance system that restrained capital accumulation, inhibitions on pooling resources that discouraged investment diversification, and a traditional aversion to the concept of legal personhood for corporations, which hampered the development of financial entities.

If there is a lesson for the future of Islamic finance from medieval Christian finance, it is that the roots of its decline lay in societal changes to the fragmented, feudal society of Europe of its time. Agricultural, Church-dominated economies were superseded by new forms of social organization–nascent nation states with central political institutions, urban, commercial economies and lay patronage of intellectual and cultural life.

Medieval Italian merchants developed commercial and financial techniques, such as bookkeeping and bills of exchange, that spread north and west to Europe’s emerging maritime and Protestant powers, notably Holland and England. The development of the concept of public debt also allowed cities and nations to finance their commercial expansion and to develop trade, magnifying the need for competitive financial services.

This fluid mercantile society was not necessarily less religious than medieval Europe, but it was less hierarchical and more concerned with secular objectives. Republicanism, liberty, law and justice became not just political imperatives, but commercial necessities.




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