Conventional Western finance has been unable to reduce exposure to instability or to contain risk. As the world stands on the brink of another major economic recession, prompted by the COVID-19 pandemic, the failure to address this financial structure’s flaws is evident. The last financial crisis was fixed using costly bank bailouts, which did not convert to benefits for the average borrower or “Main Street” economic activity. Some economists urged tighter regulation or stricter control on capital movements. But few addressed the root of the unethical character of Western finance, taken as a whole.
Such weak structural ethics have encouraged speculative practices and the pursuit of personal, rather than collective, profits. It’s still unclear how the markets (highly inflated) will react after the world shifts away from the medical scare to the economic aspects of the pandemic. What is clear is that there will be a quest for new economic/financial strategies, based on rules, principles, and mechanisms that differ from those that have prevailed until now. Rather than looking for a new invention, the West should consider borrowing from Islamic financial principles.
Western banks have already offered Islamic banking products to diversify clients’ portfolios; they have done so in the spirit of 21st century Wall Street capitalism, avoiding the more interesting and desirable effort to adopt the philosophy of Islamic finance on a wide scale.
ESG Fails to Address the Core Problem
The West has been exploring the concepts of social responsibility and sustainability in the economy – placing special emphasis on the environment and on the so-called green economy. While major institutions and corporations have paid lip-service to sustainability (using the acronym ESG: Environmental, Social, and corporate Governance), Islamic finance treats it as the structural pillar of how an economic system ideally functions. It goes much further than ESG in identifying and adopting mechanisms to control the biggest problem of any economic model: greed. And that is where the West has much to learn.
It is essential to note that Islamic finance favors entrepreneurship—it is pro-capitalism.
It is essential to note that Islamic finance favors entrepreneurship—it is pro-capitalism. Yet it also believes that a more equitable distribution of risk and gains is possible. This means that no one can gain outperforming profits without participating in the risk of a loss. And in that sense, Islamic finance is much closer in spirit and practice to the ideals set out by Adam Smith in “The Wealth of Nations” than is present-day Western finance, which – as a result of the steadfast rise of finance and rent seeking activities at the expense of the manufacturing economy – has turned banking into the markets’ primary function, fueling speculation and risk.
Western banks have already begun offering Islamic banking products to diversify clients’ portfolios. (Photo via United West)
The COVID-19 pandemic could trigger an economic transformation in the West, but it could also devastate developing countries (sharply lower remittances from migrants alone have cost billions), reversing years of improvements. Whether or not the world’s economy will fall by five or six percent as the World Bank expects, a global recession seems inevitable. And the United Nations predicts that, because of the dramatic impact on poorer countries, some 420 million people could fall into “extreme poverty” (meaning earnings of less than US$2/day).
The pandemic has simply interrupted the processes that evolved into the current state of globalization. The globalized economy has acquired the characteristics of an epochal shift. Naturally, significant economic shocks cause political change. In that sense, the coronavirus pandemic could spell the collapse of the neoliberal system that began with Thatcher and Reagan in the 1980s and that gained hegemony with the collapse of the Berlin Wall.
The extent of the pandemic’s economic ruin represents a threat to consolidated and emerging democracies alike.
The extent of the pandemic’s economic ruin represents a threat to consolidated and emerging democracies alike. Quantitative easing and other solutions masquerading as economic stimulus have merely served to sustain the financial markets, but no one knows how long that can last. Many are looking for solutions to address the inherent dysfunctions that the pandemic has exposed.
Until now, the 2008 subprime mortgage crisis served as the ultimate example of the vulnerabilities of the Western economy. The pandemic has shaken its foundations, rendering it too weak to sustain another, even if improved, version of the system. Rather, what’s needed is an entirely new concept of the market with deeper links to moral principles and reduced mechanisms for pure speculation. Ever since the fall of the Berlin Wall in 1989, Western finance has increasingly avoided ethical considerations about its role in the economy and society, becoming more parasitical and self-serving.
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It’s Time to Adopt the Principles of Islamic Finance
One of those solutions might well involve the adaptation of some of the principles of Islamic finance. Over the past decades, Western banks have offered Islamic banking services to address a significant niche demand in the market for such products. The pandemic’s economic disruption, however, could encourage an actual philosophical recasting of the role of markets and banking in Western societies based on the very principles of Islamic finance.
Kuwait Finance House ranked “Best Islamic Financial Institution” by Global Finance’s 2020 Islamic Finance Awards. (Global Finance Magazine, May 12, 2020)
After all, if Islamic finance has the social tools that have helped majority Muslim countries cope with the pandemic fueled economic crisis, Western societies might also benefit from the basics, that is Sukuk[1], Waqf[2], and Zakat[3]. The latter has allowed families to cope, compensating them for lost income in societies too poor to afford public education or healthcare.
The main technical obstacle to Islamic finance is one of perception, due to the prevalence in the Western media of a distorted image of Islam.
The main technical obstacle to Islamic finance is one of perception – and a highly murky one at that, due to the prevalence in the Western media of a distorted image of Islam. That is where Islamic finance faces an uphill struggle for wider acceptance.
More information can help improve the perception as does any effort from formal Islamic institutions to encourage and promote investments in Shari’a compliant products. But there are still few technical mechanisms that facilitate the trading of Islamic bonds or other financial products, compromising recognition from central banks in Europe or North America. Nevertheless, despite the different traditions and cultures between the “East” and the “West,” the principles of Islamic finance can be adopted on their own.
A teller at Bank Mandiri in Indonesia, which offers Shari’a compliant banking options. (Photo via Reuters)
Islamic finance need not be circumscribed within an Islamic reality, all cultures and traditions can understand the idea of shared risk. Besides, as some Arab states have become richer, many parts of the world have witnessed a far greater presence of Islamic financial institutions. Moreover, it should be noted that modern Islamic Finance is itself an adaptation of some of the more ethical banking mechanisms of post-World War II Europe.
Indeed, Islamic finance is based on Shari’a and the Qur’an. But, its modern iteration owes to Ahmad al-Najjar, a German-trained Egyptian economist, who imported and adapted the mechanisms of German cooperative banks in the practices of a rural savings bank in the village of Mit Ghamr.
Islamic finance cannot produce the kinds of crises that have caused havoc on Wall Street – from the 1929 crash to the subprime collapse of 2008 – because it does not tolerate extravagant risk. And it does not tolerate debt. Loans are always backed by a solid capital structure in order to limit the risk of default.
Islamic finance cannot produce the kinds of crises that have caused havoc on Wall Street because it does not tolerate extravagant risk.
Consider that the subprime crisis was the result of trillions of dollars’ worth of loans (mortgages) being packaged into financial “products,” themselves becoming the object of speculation and, quite literally bets on bets (which is a rough way of defining a derivative). And all of it lacking an adequate capital structure to protect the banks from the risk of default. A financial system, even partially based on Islamic principles, would have prevented the kind of speculation that led to the sub-prime collapse in the first place.
Islamic finance aims to achieve an equitable distribution of the potential profits and potential losses according to the principles of Mudarabah[4] and Musharakah[5] contracts. These principles establish the characteristic risk-sharing techniques of the Islamic financial system. The key is that banks do not lend money; they invest in ventures or assets, sharing the investment risks in exchange for a right to share in the profits that the beneficiary has achieved thanks to that investment.
This effective link between profit and loss encourages caution; it discourages risky credit as well as the accumulation of debt. Creditors are more akin to partners than lenders, sharing the risks and rewards, establishing greater discipline in the system. In order to avoid financial crises on the scale of the 2008-2009 recession, adopting Islamic finance might lead to more ethical practices, at the very core rather than simply as a niche alternative such as ESG (energy, sustainability, and governance).
Interest on Debt: The Main Problem
In total contravention to Western finance, Muslims cannot benefit from economic activities that involve interest, uncertainty, and speculation. In other words, the concept of “interest” on loans is anathema – or haram. As the 2008 crisis showed, nothing more than interest serves to fuel the spiral of poverty, hurting average borrowers while benefiting the rich, who achieve even greater wealth.
As the 2008 crisis showed, nothing more than interest serves to fuel the spiral of poverty, hurting average borrowers while benefiting the rich.
The problem is that wealth from interest does not result from the kind of productive economic activity that benefit a large number of people. Such profit is parasitical in nature. And surely, even a soft interpretation of this Islamic banking practice would not challenge the ideas of Western capitalism. Credit card companies and banks have profited immensely from charging exorbitant interest. They can still profit from tighter parameters for what constitutes fair interest.
Moreover, Islam is not the only religion to consider interest immoral. Many faiths, such as Judaism, Christianity, Buddhism, and Hinduism, reject interest.
It has taken a virus to bring neoliberalism and its offshoots into question. And it is the second time in little over a decade that the financial-market dominated economies of the West have been forced to confront their fundamental flaws. The Great Recession, sparked by the Lehman Brothers collapse, has already raised significant questions about the sustainability of the short-term speculation and financial alchemy that characterized the economic shift of the 1990s.
During the current pandemic, hundreds of corporations have left employees stranded on unpaid leave at home even as the stock market has continued to set records, while many CEOs continue to earn hundreds of times more than the average worker. The entire economic system in the West has been put on notice.
Neoliberal economics is based on the overwhelming acceptance that markets can regulate themselves, that capital flows to where it is most needed, and that systematic risks are predictable. The world will have witnessed two catastrophic economic crises since neoliberalism became popular.
The effort to reshape capitalism and economic thinking must begin at the ethical and philosophical level.
Before we can expect Wall Street and other financial centers to notice the dystopian effects, let alone do anything about it, the effort to reshape capitalism and economic thinking must begin at the ethical and philosophical level. It’s not surprising that the Vatican, through its official organ Osservatore Romano has proclaimed neo-liberal ideology as “the number one enemy” in the post-crisis phase.
Islamic finance would not tolerate “virtual” assets. Thus, it leaves no room for arcane financial instruments, the kinds of leverage typical of the late 1980s takeovers, short selling, and risky lending. Islamic finance requires full disclosure of the risks of a transaction. This is because the goals of Islamic finance are not to produce value for investors; but rather to promote socio-economic justice.
Its entire philosophy is to make the economy as fair as possible – without renouncing the fundamentals of the market. And that’s why, unlike pure communism or socialism, Islamic economics can present itself as a viable alternative to the present financial system. And it does so not by removing concepts of profit, competition, and free-enterprise; instead, it wants to frame the latter within a moral structure, aimed at achieving a more equitable distribution of wealth.
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[1] Sukuk: Shari’a compliant bonds, sometimes described as “certificates of co-ownership,” involve shared ownership of material assets relating to a given project or investment activity.
[2] Waqf: endowments, typically real estate, established as a donation to interest beneficiaries, either family members, the poor, scholars, or the general population.
[3] Zakat: charity, as a religious obligation prescribed by the Qur’an and one of the Five Pillars of Islam, which demands Muslim to allocate a given percentage of their wealth to charitable organizations. Typically, Islamic banks in any transaction apply the zakat and deposit it with philanthropic organizations, and a record is kept in the balance sheet.
[4] Mudaraba refers to a fiduciary loan, typically in a new business – it would be most useful in a startup – wherein one party provides monetary funds while the other party builds the activity/does the work.
[5] Musharaka represents a mechanism to share profits between two parties, who both supply the resources and the management of a business, forming a partnership / joint-venture. The distribution of future profits is established when the contract is stipulated, as is the proportional division of losses in the event of failure.
