Islamic finance and the new financial system pdf

ISLAMIC FINANCE AND THE NEW FINANCIAL SYSTEM – Book Sample

A Brief History of Financial Systems and the Birth of Money

Most of us know very little about our financial system and its history. Even though I had worked in the banking and finance industry for close to two decades, I knew very little about the financial system’s history until I started doing my research. I was surprised to learn that our current financial system is only about 43 years old. I knew that the world had been using paper currencies for hundreds of years and that, before this, coins were used, mainly gold and silver. However, the circumstances for the shift from coin

to paper as well as the shift to fiat currency were all new to me.

What I came to realize was that our financial system moves in cycles much like an economy does. It goes through periods of growth and expansion and then decline. There have always been crises in financial systems. No financial system has ever been perfect and free of flaws. Crises can be sparked by many factors — wars, speculation (bubbles), runaway government borrowing and spending, and government mismanagement of the economy or its currency.

To understand where we are and where we are heading, we must first understand where we have been, beginning with the history of money and financial systems. Literally hundreds of books have been written on early currencies and financial systems. This topic alone deserves time to explain in detail. However, to keep focused on the topic of this book, I will attempt to summarize the evolution of currencies and financial systems in this chapter.

EARLY FINANCIAL SYSTEMS AND CURRENCIES                        

Financial systems existed long before gold and silver were used as a medium of exchange. One of the earliest forms of money was cattle and other ani- mals, which were used as a medium of exchange and a store of value as early as 9000 BCE.

fines were paid in oxen and sheep.2 Sacks of grain, salt, and even seashells have been used as a form of currency for trade at one point in time.³ Thus, trade, taxation, and payment of fines existed before metal coins and money as we know them today were used.

There is even some research supporting the idea that debt and credit existed before coins and other money came into existence.⁴ According to David Graber’s research and his book, Debt: The First 5,000 Years, the first recorded credit and debt systems developed more than 5,000 years ago as means of accounting. Credit and debt existed in the Sumerian civilization around 3500 BCE. In this system of credit, farmers would often become so indebted that their children would be forced into slavery as a means to repay the debt. These debt slaves were periodically released by kings, who canceled all debts and granted them amnesty under what came to be known as the Law of Jubilee in ancient Israel. One of the conclusions of this research was that indebtedness throughout history often led to unrest, insurrections, and revolts.

Though barter was also used throughout ancient societies, it was never a complete system or means of account, as other social factors came into play. Social currencies (i.e., interaction among the community and mutual expectations and responsibilities among individuals) completed early finan- cial systems. Social bonds were also created through gifts, marriages, and general sociability. This type of economy stood in contrast to the moral foundations of exchange, based on formal equality, reciprocity, and hier- archy. This system established the customs in a society, which also led to the development of caste systems (the “haves” and the “have nots”).5

One of the first written codes of law mentioning money and debt was the Code of Hammurabi, enacted by the Babylonian king Hammurabi, who ruled from 1792 BCE to 1750 BCE.6 The code consisted of 282 laws dealing with a wide range of matters, from trade to family relationships. Nearly half of the code dealt with laws for contracts, the establishment of wages, interest rates on debt, inheritance, and property rights.⁷

The first mention of the use of money within the Bible is in the book of Genesis,⁸ which refers to the criteria of the circumcision of a bought slave. There are other early references to money going back as far as the twentieth century BCE, such as Abraham’s reference to the purchase of the Cave of the Patriarchs.⁹

An example of an ancient currency is the shekel. It was an ancient unit of account used in Mesopotamia around 3000 BCE¹⁰ to define both a specific weight of barley and equivalent amounts of materials such as silver, bronze, and copper.

The use of coins later developed primarily as a means to pay soldiers in ever-expanding empires around the world. The rise of great empires in China, India, and the Mediterranean was marked by extreme violence as these empires grew and required more and more resources to pay for their expansion. In this way, coins developed to pay soldiers in far-off lands as well as to enforce the payment of taxes by the state’s subjects to subsidize its growing armies. Around 1000 BCE, money in the shape of small knives and spades made of bronze were in use in China. The first manufactured coins appeared in India, China, and cities around the Aegean Sea between 700 and 500 BCE.¹¹

GOLD AND SILVER                                                             

Throughout history, gold and silver have been the most common form of money. In many languages, such as Spanish, French, and Italian, the word for silver is still directly related to the word for money. Although gold and silver were commonly used to mint coins, other metals were used, such as iron and copper.

The earliest known records of gold and silver being used for monetary exchange date back as far as the third millennium BCE, when gold, specif- ically, was used in Mesopotamia and ancient Egypt.¹² The first gold coins were minted in Lydia (modern-day Turkey) during the Grecian age around the year 700 BCE.¹³ By the fourth century BCE, coins had become widely used in Greek cities. The coins were supported by the city-state authori- ties (the issuing authorities), who strived to ensure they retained their value regardless of fluctuations in the availability of whatever base precious metals they were made from.

Once well-established in Greece, the use of coins spread slowly west- ward throughout Europe and eastward to India. By the second century BCE, coin usage in India had become central to commercial transactions. Mone- tary systems that were developed in India were so successful that they spread through parts of Asia well into the Middle Ages. During the fourteenth cen- tury, much of Europe had converted from use of silver in currency to minting of gold.14

Metal-based coins had the advantage of carrying their value within the coins themselves. One disadvantage, however, was that they could be manipulated. The clipping of coins was a fairly frequent practice. The clippings were then traded and recycled.

Governments, over time, also had the habit of diluting the precious metal content in coins, such as blending copper with gold or copper with silver. This, of course, caused inflation and, in some cases, loss of faith in the issuing authority. Governments did so because they were short on precious metals and had bills to pay.

A bigger problem was the use of coins made of different metals — copper, gold, and silver in Europe. Gold coins, for example, were valued more than….

Overview and History of Islamic Finance

Looking back at past financial crises, we can see how debt plays a significant role in building up to a crisis as well as the ensuing pain it causes once a crisis is sparked. A high level of debt, however, is not the cause of a crisis; it is merely a symptom of other problems in the financial system. Take, for example, the global financial crisis of 2008. The high level of debt consumers were taking on was not the problem; it was a symptom of the loose lending standards that had become prevalent in the United States and elsewhere.

There were three other problems in the system that led to the unsustainable increase in the level of debt: low interest rates, which encouraged more borrowing; lax regulation and oversight, which led banks to take on more risk and engage in fraud; and financialization of the economy, leading to engineering of new and complex financial products, such as credit default swaps (CDSs).

This financial engineering not only gave the industry, and the economy, a false sense of security, it also resulted in an overbloated financial industry that continued to play a bigger role in the economy while

productive industries, such as manufacturing, play a lesser role.

So if rapidly rising debt is a symptom of the problem, what can be said today, six years after the worst financial crisis the world has seen since the Great Depression? According to the Bank for International Settlements (BIS), the amount of debt globally has risen to more than $100 trillion in 2013, up from $70 trillion in 2007.1 In other words, to save the global economy from the financial crisis, governments and central banks threw even more debt at the problem.

Though this may seem to have calmed markets, it has only made the system more unstable and ensures that the next crisis will be even worse than the previous one. One of the clearest indications that this debt-for-growth path is not working is the fact that the additional

$30 trillion in debt in the system since 2008 has done little to bring the world economy back to a normal growth level. The law of diminishing returns has caught up to this debt model.

What then are some solutions to this dilemma? I will discuss some of the solutions being proposed by economists and financiers in Chapter 11, but for now I would like to look at a financial system that is not being discussed: the Islamic financial system.

ISLAMIC FINANCE DEFINED                                                 

Islamic finance is a financial system that operates according to Islamic law. Islamic law, called Shariah, is derived from the Quran, the Hadith, and the Sunnah. The Quran, Islam’s holy book, which Muslims believe to be the unalterable word of God, is said to have been revealed to the Prophet Muhammad (PBUH)∗ between 610 CE until his death in 632 CE. The Hadith is the narrative relating the actions and sayings of Muhammad.

 The Sunnah is the life and example of Muhammad. In addition to these three sources, Shariah also relies on ijma, qiyas, and ijtihad. Ijma is the consensus among religious scholars on issues not explicitly mentioned in either the Quran or the Sunnah. Qiyas is the use of deduction by analogy to provide an opinion on a case not referred to in the Quran or the Sunnah. Ijtihad rep- resents a religious scholar’s or jurist’s independent reasoning relating to the applicability of certain Shariah rules on cases not mentioned in the Quran or the Sunnah.2

When the basis of Shariah (Quran, Sunnah, and Hadith) is combined with ijma, qiyas, and ijtihad, it forms what is called fiqh, otherwise known as Islamic jurisprudence. Fiqh has played a leading role in the recent development of Islamic finance and Islamic banking around the world.

Although Islam has been around for more than a millennium, Islamic finance as an industry and a financial system is still very young, having been  around  for less than 40  years. Islamic theories of economics  and commerce have been around as long as Islam itself. As Islam spread across the Middle East, Asia, North Africa, and later southern Europe, it brought with it a renewed interest in science and the acquisition of knowledge.

This period, from the birth of Islam in the sixth century up to the twelfth century, is known as the Golden Age of Islam. During this age, the major Islamic capital cities of Baghdad, Cairo, and Cordoba became the main intellectual and learning centers for science, philosophy, and medicine. Muslim scholars advanced the knowledge gained from the ancient Greek, Roman, Persian, Chinese, Indian, and Egyptian civilizations and went on to make new discoveries in these fields. These advancements would later spark the European Renaissance.

Muslim scholars also worked on theories of economics and developed trading tools and contracts such as sukuk (promissory notes), mentioned….

Preventing Future Crises— Real World Solutions from Islamic Finance

With a better understanding of Islamic finance and a look back at the history of money, financial systems, and financial crises, let’s see if there

are any lessons to be learned from Islamic finance. I’m not suggesting that Islamic finance take over the global financial system, but I would like to see its concepts and philosophy become accepted as offering ethical solutions to issues we face repeatedly in our financial system.

Before looking at possible solutions, we must first define the problems in our current system and understand why we keep going from crisis to crisis. We must also look at the reasons these crises are increasing in severity and why nothing has been done so far to fix the problems. The big question in the end is, what will it take for our financial system to change? Once these questions are addressed, we can see what solutions, if any, Islamic finance has to offer.

In Part I, I covered the history of money, past financial systems, financial crises, and the buildup to the next major crisis. The main cause of the boom-and-bust cycle of our financial system is the foundation upon which it is built. If the foundation is bad, the entire system is bad and can be fixed only if the foundation is replaced. The foundation of our financial system is money — fiat money — which is supported by the ever-growing mountains of debt. Our fiat money system is held together only by government promises. History has shown us that governments break these promises 100 percent of the time, yet we keep hoping that the next time will be different.

For our economies to grow, they must be pumped with an ever- increasing amount of debt. By now it should be obvious that much of it will never be repaid. If the overall level of debt in the system stays constant or, god forbid, drops, then the systems crashes, as you can see from Figure 10.1.

The current global financial system began in 1971, after the United States dropped out of the Bretton Woods Agreement, which removed any backing of the U.S. dollar other than the government’s promise. The rest of the world followed, creating our fiat money system.

The results of being on this system for the past 43 years can be seen by the divergence between GDP growth and debt growth shown in Figure 10.1. Overall debt in the United States, both government and private, has shot up at an increasing rate since 1971.

The slight blip on the debt line in 2008 was the result of the global financial crisis. Thus, a decline in overall debt leads to a recession. It also leads to a decline in the money supply, since new money is issued only on the back of new debt, regardless of whether it is government debt, corporate debt, or consumer debt. Every new paper or digital dollar coming into the market is a result of another dollar in new debt being issued. Without bigger and bigger mountains of debt, the system collapses.

This is why governments and central banks stepped in with such force during the most recent crisis; they took on the role of debt issuers, since corporations and consumers were overloaded with debt. This trend continues to this day, with governments taking on more debt than they can ever repay in the hope that all the new debt will kick-start economic growth. This should be the clearest sign of the

fragility of our system and the brick wall it is headed toward.