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Principles of Islamic Finance

Principles of Islamic Finance. The Two Pillars of IF. For-profit domain Non-profit domain A balanced approach. Like a bird, an economy needs the two sectors to fly. Non-profit Obligations. Zakat Nafaqat Sharing in times of necessity, starvation, or hardship. Zakat.

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Principles of Islamic Finance

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  1. Principles of Islamic Finance

  2. The Two Pillars of IF • For-profit domain • Non-profit domain • A balanced approach

  3. Like a bird, an economy needs the two sectors to fly

  4. Non-profit Obligations • Zakat • Nafaqat • Sharing in times of necessity, starvation, or hardship

  5. Zakat • Obligatory donation • Applies to idle money (not used for one year) • Measure against hoarding • Hoarding and the current financial crisis?

  6. Nafaqat • Obligatory spending for designated relatives • Parents, family, close relatives • Subject to need

  7. Why Markets Need Non-profit Actions? • Safety net • Distribution of wealth

  8. Why Do We Need Both? • Happiness cannot be achieved by one domain • Balance allows both to flourish and thrive

  9. For-proft Domain

  10. General Principles • Prohibition of israf • Prohibition of usury or riba • Prohibition of gharar or wagering

  11. Israf • Over-spending or over-utilization of resources • In consumption: • extravagant spending • Conspicuous consumption and status games • In investment: • Greed—”irrational exuberance” • Bubbles => crashes

  12. Wealth Preservation • Wealth preservation is an essential objective of Shari’ah • Israf violates preservation of wealth • Results: pollution, global warming, depletion of resources • Essence of economics is to avoid israf

  13. Riba

  14. Definition • Riba or usury: any stipulated addition over a loan • Includes both simple and compound interest

  15. Riba • Prohibited by all divine religions as well as Buddhism • Two-thirds of world population subscribe to this belief

  16. What's Wrong with Riba? • Debt grows faster than wealth • Debt cannot be paid except with new debt • Debt burden destroys the economy

  17. 1 pence borrowed at 4% in 1 AD In 1750 debt equals weight of the globe of gold In 1990 it equals 8190 globes!

  18. Debt in the US, $billions

  19. Figures • Average growth annual rate: • Debt: 39%, • GDP: 21%, • M2: 19% • Debt-GDP ratio: 1.3 to 2.2 • Debt-M2 ratio: 2.2 to 4.2

  20. Inverted Debt Pyramid Debt Wealth

  21. Financial Instability • Inverted pyramid is not sustainable • Crashes needed to “clean up” the system • Then debts start to accumulate again faster than wealth • Recurrent crashes • Very costly to maintain the system

  22. Restrictions on Debt • Theory: Intertemporal Budget Constraint: • The present value of debt go to zero • Prevents Ponzi financing • Reality: E.U. requirements: • Deficit < 3% of GDP • Debt < 60% of GDP • Problem: Need to govern debt from the ground-up

  23. Islamic Finance • Debt creation is integrated with wealth creation • For-profit debt must be contractually embedded in real transactions • Islamic modes of finance: • Deferred sale; salam; leasing;

  24. Deferred Sale • Sale of a good for a deferred price • Price includes markup • Time value is paired with real value • Murabaha: Financing deferred sale

  25. Salam • Opposite of deferred sale • Price is spot; good is deferred • Time-value is reflected in lower price

  26. Normal Debt Pyramid Debt Wealth

  27. Gharar

  28. Definition • Gharar is risk with delusion or deception • Risk: likelihood of loss or failure • Two types of gharar: • Degree of risk • Form of contract

  29. Degree of Risk • Ex ante measure • Gharar if Prob (loss) ≥ Prob (gain) • Example: Lottery • Where is delusion? • Luck vs. skill • Low likelihood of success means low skill • The need for “feasibility studies”

  30. Structure of Contract • Ex post measure • Gharar if it is a zero-sum game • Examples: • Gambling • Sale of a lost car • Sale of a closed box • Why play a zero-sum game?

  31. Game Structure (A , B) (− , +) (+ , −)

  32. How to Know it is Zero-sum? • A zero-sum game cannot be played if the two parties know in advance who will win • Steps: • Select first outcome • If one player refuses to play, it is a zero-sum outcome • Repeat with other outcomes • If all outcomes are zero-sum, the whole game becomes a zero-sum game

  33. Types of Transactions Zero-sum Positive-sum Mixed

  34. Positive-sum Deals • One party gains only if the other does • Interests are always aligned

  35. Partnership (musharakah) (A , B) (− , −) (+ , +)

  36. Mixed Games • Contains zero-sum and positive-sum outcomes • If the zero-sum outcome is dominant, it is excessive gharar • If not, it is minor gharar • Game acceptable if the positive-sum outcome is dominant

  37. Crop-sharing (muzara'ah) (Land lord , Farmer) (+ , −) (+ , +)

  38. Relation of Types of Gharar • Zero-sum games are always high risk • High risk deals invite zero-sum games • High-risk: speculation • Zero-sum: gambling

  39. Relation of Riba and Gharar • Riba: separates time from real transactions • Gharar: separates risk from real transactions • Time and risk are two sides of the same coin • Riba implies gharar and vise versa • Both allow obligations to grow independent or real wealth => inverted pyramid

  40. Conclusion

  41. Nature of Islamic Finance • Universal principles • Economic ground • Balanced approach

  42. Thank You!

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