Introduction to Islamic Banking and Finance. M Kabir Hassan
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on their (i) marginal rate of substitution between current and future consumption, (ii) reward to variability ratio of the investment undertaking, and (iii) the degree of loss aversion in their preferences. They will reveal their preferences by responding in terms of making different levels of capital investments at different levels of profit-sharing ratio. Steep indifferences curves, i.e. higher marginal rate of substitution for intertemporal consumption and loss aversion, would make them demand a higher profitsharing ratio for themselves. On the other hand, a higher Sharpe ratio (i.e. higher reward to variability ratio) of a potential investment under-taking would enable them to reap the target level of return even with a lower profit-sharing ratio. Sharpe ratio is the excess return on investment divided by the standard deviation of the return.
In addition to that, in an economy, there will be individuals or groups of individuals who would be looking to pursue productive investments, but remain short of funds. Such individuals would require capital investments. In return, they would offer profit sharing in the investment undertaking. As is the practice, the ex-ante profit-sharing ratio is offered by saving deficient units looking to source finance. The factors that determine this offered profit-sharing ratio include the (i) amount of capital needed, (ii) duration of investment, and (iii) reward to variability ratio of the investment undertaking. The greater the capital requirement and the duration of investment undertaking, the higher will be the offered profitsharing ratio. However, the higher the reward to variability ratio, the lower will be the offered profit-sharing ratio.
Unlike the debt based financing where the savers and investors have the opposite reaction to the rate of return since the return for savers is the cost to the investors, the interest-free equity financing based capital markets do not have an inherent tension between savings and investments. Both react uniformly to the internal strength of the investment undertaking, i.e. reward to variability ratio.
Since there is no fixed return to money capital alone in the loanable funds market, all savings must necessarily be invested in the real economy to earn any return. If no return is required, then surplus savings can be either paid to the charity or given as interest-free loan. However, any return on investments will have to be earned in the real economy. The equilibrium is shown in Figure 2.1 where the horizontal line represents the saving deficient units demand for capital investments whereas the upward sloping line illustrates the saving surplus units supply of investable funds at the different levels of profit-sharing ratios. Equilibrium occurs where at the equilibrium profit-sharing ratio the amount of capital invested by the investors equals the capital investment required by the firms.
The higher capital requirement, longer duration of investment and lower Sharpe ratio will compel the firms to offer a higher profit-sharing ratio and vice versa. Figures 2.2 and 2.3 show both the downward and upward shift in SDU investment demand curves.
Figure 2.1. Equilibrium in the interest-free asset market.
Figure 2.2. Downward shift in SDU curve.
An increase in the Sharpe ratio of an investment indicating greater strength of the project will shift the SDU curve down as well as shift the SSU curve to the right. Thus, firms sourcing funds can source the required funds at a lower profit-sharing ratio as the SSU curve becomes flatter and shifts to right following an increase in Sharpe ratio.
Figure 2.3. Upward shift in SDU curve.
On the other hand, greater impatience in the consumers would make their indifference curves steeper and hence shift the SSU curve to the left. Furthermore, higher loss aversion would also result in the SSU curve becoming steeper. As a result, firms will have to respond by increasing the profit-sharing ratio for inducing patient and loss averse consumers to engage in capital investments. Figures 2.4 and 2.5 show both the right-ward and leftward shift in SSU investment supply curves.
Thus, the preceding analysis shows that movement in the profit-sharing ratio can perform the asset allocation function in the interest-free capital market. Furthermore, investment acceleration can be achieved through institutionalizing Zakat which levies a charge on idle wealth. In an economy where there is a prohibition of interest, the surplus and idle wealth would accelerate the conversion of saving into investment. Thus, it can enhance the scale of decent employment opportunities and contribute to economic growth. Even those savers who would not like to directly invest in stocks of new start-ups or small companies, they will invest through financial intermediaries like banks and mutual funds to minimize their risk by diversification and effective asset reallocation by skilful fund managers who could monitor the performance more effectively and efficiently on investors’ behalf.
Figure 2.4. Rightward shift in SSU curve.
Figure 2.5. Leftward shift in SSU curve.
In addition to that, since there is no return on money balances and direct participation possibilities in the investment projects through asset markets, there will be a lower risk for the economy to fall in a liquidity trap. The liquidity trap is a situation in economy when people tend to hold onto their cash balances rather than investing them in return-generating investments when the return on such investments is very low. Haque and Mirakhor show that due to no compulsion of paying interest as a cost, the rate of return to both saving surplus units and saving deficient units from the productive enterprise will increase and will cause the aggregate savings to increase.2 Due to the prohibition of interest, these savings will be converted into investments and will contribute to employment generation rather than sitting idle and earning stipulated increase at the rate of interest without any regard to the real economic activities.
The effects of Islamic capital market operations on the macro economy are also positive. There is less pressure on the current account balance if there is no or limited gap between savings and investments. In an open market economy, the gap between savings and investments is filled by the current account balance. Thus, a stable current account can have a stabilizing effect on the exchange rate and on domestic currency as a store of value in the interest-free economy. In an empirical study of 15 Muslim majority countries, it has been found that interest-free money is more stable than interest-bearing money.3
2.4Islamic Banking for Short-Term Financing and Investments
Academic literature that discusses the philosophy and rationale of banking as an institution explains the rationale for having banks as institutions that bring efficiency in intertemporal trade, distribute risk, deal effectively with asymmetric information and provide an effective means of monitoring.
Islamic banking enables short-term intertemporal finance between risk averse investors and individual and corporate clients who require short-term finance. Risk averse investors want to minimize risk and delegate the responsibility of credit portfolio monitoring to the Islamic banks. There are certain short-term finance needs that might be difficult to finance through long-term equity finance or which can be more efficiently funded through employing trade and lease based modes of financing. Interest-free Islamic banking primarily caters to short-term finance needs involving an asset and the investor client base of Islamic banks are investors who want to smooth the path of consumption through regular incomes with limited chances of risk. Thus, Islamic banking investments are suitable for impatient,