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ISLAMIC MONEY AND BANKING – Book SAmple

The Role of Conventional and Islamic Banks in Investment: Certainty and Risk Conditions

In general, conventional banks perform two functions: to collect deposits and issue loans. The system guarantees the depositor a predetermined return on the nominal value of the deposit and, in most cases, the deposits themselves are insured (for example, FDIC). On the other hand, a borrower pays a predetermined rate on the amount borrowed and has to provide collateral to guarantee the principal and interest.

Thus, the role the banks play in the economy is essentially a passive role in the sense that their operations are quite inflexible in the face of any economic fluctuations. As the result, it has rightly been said that in these banks ‘‘… since the nominal value of deposits is guaranteed… shocks that can lead to banking crisis can cause divergence between real assets and real liabilities, and it is not clear how this equilibrium would be corrected and how long the process of adjustment would take.’’¹ This is the real essence of a traditional bank’s function as a fund intermediary.

Banks in the Islamic system (that is, interest-free or equity-based banking) should operate ‘‘two windows’’:

One window would cover only transaction balances and would pay no fixed or predetermined return on deposits, and also there would be no possibility of using… deposits as a basis for multiple credit creation… The other window would be the profit-and-loss, or equity, account in which a depositor would be treated exactly as if he were a shareholder in the bank.²

On this basis, it has been shown that: The Islamic system may well turn out to be better suited than the interest-based, or traditional, banking system in adjusting to shocks that can lead to banking crises. This is because in an equity-based system, shocks to asset positions are immediately absorbed by changes in the nominal values of shares (deposits) held by the public in the bank. Therefore, the real values of assets and liabilities of banks would be equal at all points in time.³

Once this distinction between interest-based and interest-free bank- ing practice is clear, the only logical conclusion to draw is that the conventional banking system (CBS) plays a passive role in the econ- omy and therefore cannot be considered to be part of the system. Its role is essentially a parasitic one, and it is for this reason that the supply of money has always been treated as exogenous and its volume is not affected by other economic variables.

By contrast, through supplying investors with capital, the Islamic banking system (IBS) plays an active role in the economic system, making it an integral part of the Islamic economic system. The role of the CBS in creating and controlling the quantity of money in the economy makes it a monetary institution. Because the IBS does not have the power to create money but, rather, supplies the capital needs of investors and acts as a shareholder, it is a financial institution that implements financial policy.

The money market is the most essential element in the CBS but as soon as interest, in any form, is prohibited, the money market will be eliminated from the economic system.⁴

Money is treated as a private good in the capitalist system and banks, which are profit maximizers, produce this commodity. The Islamic economic system, in which money can be viewed as a ‘‘public good’’⁵ and as potential capital, presents an entirely different picture. The vital role of banking in any economic system is reflected in the way banks finance investment projects.

 The most that can be said about the CBS, under the certainty condition, is that it provides debt-capital to investors. Not all the money created by the CBS increases the stock of capital; a considerable portion is channeled for speculative purposes (in the money market). Predetermined and fixed interest charges on all debt-capital, independent of its productivity, can legitimately be regarded as a cost of capital in this system.

Since the IBS, under the same condition, does provide equity-capital to investors, it behaves as a shareholder. The bank’s share of total profits earned in an investment project cannot be considered part of the costs. Furthermore, since a) the IBS can have a share in almost all investment projects of an Islamic state, b) the weighted average rates of return on capital investment projects depend on every single rate of return, and c) there is no money market in the system, it can logically be deduced that the cost of capital is zero.⁶

This chapter has been divided into two parts. The first is devoted to the analysis of investment behavior of the CBS under both certainly and risk conditions, where the rate of interest is the justifiable cost (including the cost of capital) of producing goods. Under risk conditions, a risk factor is added to other costs of production and, again, it is the consumer who has to pay for this. The ultimate result is a decrease in investment expenditures and hence, a decline in aggregate demand and a loss of welfare.

In the second part, it is assumed that in an IBS all investment expenditures are financed through banks and via Musharakah contracts. It is further assumed, for simplicity, that there are only two parties (bank and investor) involved in each contract. The profit-sharing ratio between the bank and the investor affects the investor’s demand for bank capital.

The bank’s share of profit is not always proportional to its share in capital; depending upon the overall economic conditions of the state it can be equal, less than, or even greater than its share in capital. This stems from the view that money is a public good and thus the banks are state-owned institutions and cannot be assumed to be profit-maximizers. However, Islamic banks try to put all potential funds to the most desirable uses and serve the public interest. This is, in fact, the essence of the IBS and hence an integral part of a Grand Cooperative System.

In theory, the depositors in an Islamic bank share in its losses as well as its profits, so that if the bank does incur a loss, the nominal value of their deposits is reduced.⁷ However, this will rarely, if ever, happen and, in any event, the state would not allow the banks to go bankrupt. Furthermore, it will be shown below that the IBS has viable instruments which are counter-recessionary in nature.

The views about the nature of money and the ownership of banks in the IBS play the most crucial role under risk conditions. Recession has been defined from an investor’s point of view as a condition within which the rate of profit is declining. Since it is the government which has sole responsibility for developing a recessionary downturn, it has to forgo part of its share of profits to compensate for any decline in the investor’s expected rate of profit.

The ultimate result is to prevent any decline in investment expenditures and may even make it quite profitable for investors to increase their investment expenditures. Not much empirical evidence is required to prove that most, if not all, government expenditures are of this type. These expenditures are undertaken in order to improve the business environment and make it suitable for private investors to take part in investment projects.

Empirical evidence from the capitalist system suggests that while monetary policy is effective in fighting inflation, it is quite ineffective in recessionary downturns. The current recessionary conditions being experienced in even the most advanced capitalist countries lend further proof of this claim.

On the other hand, this section shows that the IBS, if properly practiced, is capable of preventing recessionary downturns and, in the unlikely event of their occurrence, of alleviating them. Given that the adverse social and economic effects of recession are more harmful than those of inflation, the importance of this conclusion cannot be exaggerated.

INVESTMENT IN A C APIT ALIST ECONOMY

The single most volatile and unpredictable component of aggregate demand is the volume of investment expenditures. Consumption and government expenditures are relatively stable. If Keynes’ view about the stability of the consumption function has any validity, fluctuations in the volume of investment are greatly understated since ‘‘with a reasonably stable consumption function, investment fluctuations give rise to fluctuations in consumption, too’’ (Ackley 1961: 460).

One of the problems for which no solution has ever been found and one which can be considered the principal problem of the capitalist system is the shortage of investment, not of money. It results from an invalid comparison between marginal efficiency of capital (MEC) with the rate of interest; the former being determined in the real sector and the latter in the monetary (speculative) sector. It is the consumers —not the producers or the government — who pay the costs of risk development.

Certainty Condition

Investment has been given a position of great importance in almost all macroeconomic theories, including modern Keynesian and post-Keynesian theories as well of earlier ‘‘business cycle’’ theories. According to Ackley:

This primary role must surely reflect the observed great instability of investment, which (in net terms) fluctuate from negative to large positive numbers. On the average, (deflated) gross private investment has accounted for about

11.4 percent of (deflated) gross national product in the United States during the past 30 years, ranging from a minimum of 2 percent in 1933 to a maximum of 17.1 percent in 1950. (Ibid.)

In conventional investment theory, the optimum stock of capital is determined at the point where MEC is equal to the rate of interest (r).⁸ For justification of the cost of capital, consider the two extreme cases where the total amount of capital investment is either being financed through a bank as debt capital or through the use of internal funds (undistributed profits and depreciation allowances). In both cases, the cost of capital is the current rate of interest. In the first case, it is a real ‘‘cost’’ that has to be paid. In the second, the argument is as follows: the internal fund, if deposited in a bank, could have earned interest: therefore, the current interest yield forgone is ‘‘the’’ opportunity cost of using it.

This argument might seem logical but there are two interdependent observations that can be made about it. Since the rate of interest (r) is independent of the productivity of capital, it is always drawn (in an MEC-r graph) as a horizontal line; therefore, comparing two things of very different natures is not legitimate. A corollary to this is that despite the illegitimate comparison, the rate of interest is used as a cut-off rate.

Interest, according to Keynes, is the result of speculative demand for money (or hoarding), but, by definition, MEC measures the efficiency of capital. Is it not surprising to see one measure — the rate of interest, however fictitious — being given so much power in being used as the sole criterion for a real phenomenon such as capital?

The capitalist treatment forces one to consider both money and capital as identical phenomena whose cost is ‘‘r.’’ If this is indeed the case, why are ‘‘r’’ and ‘‘MEC’’ independent of one another? If they are different, then why is the capital market not treated differently in macro models, and the rate of profit not shown as the return to