THE CASE AGAINST INTEREST: IS IT COMPELLING?

1. THE CASE AGAINST INTEREST:IS IT COMPELLING? by M. Umer Chapra Research Adviser IRTI/IDB Jeddah (Saudi Arabia) Notes for a lecture to be delivered at the International Conference on Islamic Banking to be held in Brunei on 5-7 January 2004

2. Why a new system of financial intermediation? Is there anything wrong with the prevailing interest-based system ? • Evaluation of a system on the basis of its contribution to : • Efficiency • Ease and promptness in the transfer of funds from the surplus to the deficit sectors • Economy in transactions costs • Stability • Equity (Socio-economic justice)

3. Interest-based system was never considered to be superior on the criterion of equity. Its superiority claimed on the criterion of efficiency, why? • Confidence in the Efficiency of the system has been shaken by its persistent instability over the last four decades.

4. Call for a “New Architecture”  Sound Macro-economic policies  Sustainable exchange rates  Proper regulation and supervision • Adequate capital, proper risk management, effective corporate governance, greater transparency  Why is market discipline unable to ensure the faithful observance of these principles?

5. Reasons for the ineffectiveness of market discipline in the interest-based banking system:  As a result of the absence of risk-sharing:  Deposits are guaranteed - therefore depositors become complacent and do not monitor the banks carefully - do not demand transparency  Banks rely on the crutches of collateral, which ensures the repayment of their loans - they do not evaluate the risks carefully - tend to extend credit excessively. This promotes:  Public sector deficits  Private sector living beyond means  Highly leveraged short-term debt  Rapid movement of funds  Volatility • The greater the reliance on debt and the higher the leverage, the more severe the crises

6. Some Examples:  East Asia Crisis  Long-term Capital Management (LTCM) • Foreign Exchange Markets  Remedy lies in injecting greater discipline in the financial system – How? • Introduce risk sharing to make market discipline more effective • More effective discipline will complement the role of regulators and supervisors and help make the financial system healthier and more stable

7.  Interest-free finance is intended to inject the needed discipline into the financial system through risk-sharing:  Risk-sharing by banks ?  The bank shares in the risk with the entrepreneur  Risk-sharing by depositors ?  Demand deposits (These do not share in the risks and do not therefore get any return –must be guaranteed)  Investment deposits (These must share in the risks – just like shareholders)

8.  What about credit ?  There is credit and the rate of return is fixed in advance – Is this interest ?  There is no borrowing and lending – Rather there is purchase and sale of goods and services.  The financier bears some risk in the sales-based modes of financing : murabahah, ijarah, salam and istisna‘  Wouldn’t this bring instability: NO  Credit expands in step with the growth of the real sector  Speculation minimized as a result of risk-sharing

9.  This shows that even though Islamic finance is more difficult it can be more efficient.

10.  What about equity?  Living beyond means  Need fulfillment  Full employment  Equitable distribution?