ISLAMIC

FINANCE: CONCEPTUAL AND ANALYTICAL ISSUES FROM THE PERSPECTIVE OF CONVENTIONAL ECONOMICS
AndrewSheng
President,FungGlobalInstitute,HongKong TheThirdHolderoftheTunIsmailAliChair,UniversityofMalaya Email:AndrewSheng@fginstitute.org and

AjitSingh
EmeritusProfessorofEconomics,UniversityofCambridge LifeFellow,QueensCollege,CambridgeCB39ET,UK TheFifthHolderoftheTunIsmailAliChair,UniversityofMalaya Email:as14@cam.ac.uk

November2011

Pleasedonotquotewithouttheagreementoftheauthors.Commentsmostwelcome. ThispaperwaspresentedattheTunIsmailAliChairinMonetaryandFinancialEconomicsPublic Lectureon14thNovember2011,SasanaKijang,BankNegaraMalaysia

TableofContents

I. Introduction II. CentralTenetofIslamicFinance:AbsoluteProhibitionAgainstInterestRates

III.EthicalFoundationsofIslamicFinance IV.ModiglianiandMillerTheorems V.RiskSharing,RiskShiftingandCostsofBankruptcy VI.TheRoleoftheIslamicStockMarket VII.SummaryoftheMainFindingsandConclusion

References

TableI:AComparisonbetweenIslamicandConventionalBanking

I. INTRODUCTION

Islamic finance has come of age. Despite apparent serious setbacks (eg. interruption of payments in Abu Dhabi in 2009, the Great Recession in Western countries between 20082010 and the recent turmoil in the Middle Eastern countries),Islamicbankingandfinancehavebeengrowingataveryfastrate.The sizeoftheindustrywhichwasamereUS$150millioninthe1990`shasincreasedto nearly US$1 trillion. Although it is still a niche market and its share in world finance is quite small, it is nevertheless poised for further rapid expansion as economicdevelopmentproceeds,particularlyintheMuslimworld.Sheng(2011) estimates the current composition of Islamic finance to be as follows; there are roughly US$800 billion in Islamic banking funds; US$100 billion in the `sukuk`(Islamicbonds),andanotherUS$100billionin`Tatakaful`(Islamicinsurance). According to the latest available data released by Standard & Poors, in the first quarter of 2011, US$32.4 billon of Islamic bonds (sukuk), were issued compared withUS$51.2billionraisedinthewholeof2010.Theengineoftheglobalmarket remains Malaysia, which accounted for 58 per cent of funds raised in the first quarter. The quick growth of Islamic finance has, however, not been a spontaneous event but one carefully prepared and helped by Islamic governments and their central banks. The Central Bank of Malaysia (Bank Negara Malaysia) has been in the forefront of these efforts and has assisted the growth of Islamic finance by the establishment of an institutional framework for a clear understanding and propagationofthelawsofIslamicfinance (seefurther Mirakhor2010).Thisisno meanachievementasIslamicscholarsdisagreeonmanycrucialaspectsofshariah laws. The Malaysian governments chief objective has been to help establish regulatory and monitoring institutions that will provide an internationally accepted and unambiguous conception of laws relating to Islamic banking and financial organisations. The International Monetary Fund (IMF) has also been helpful in these and other respects together with a number of other Islamic governments(e.g.Bahrain,Sudan,Pakistan).

Apart from the IMF, a number of nonIslamic financial centres have also taken steps to encourage Islamic banking and finance. Tax laws have been revised to facilitateSharihcompliantfinancialinstrumentssuchasthelongtermsukukbonds mentioned above. A notable recent entrant in this field has been the nonIslamic centreofSingapore,whichhasstarteddoingbusinessinIslamicfinance.Anumber ofnonIslamiccountriesinEuropeincludingtheUKhavealsotakenlegalactionto facilitate Islamic banking as these countries want a slice of this fast growing market. There are, however, also examples of jurisdictions that have passed negativelegislation,usuallyonpoliticalgrounds,toprohibitthespreadofIslamic finance.ThiscategoryofcountriesincludessurprisinglySouthKoreaandperhaps notsosurprisinglysomeindividualstatesintheUS. The reasons for expecting fast expansion of Islamic finance lie not only in the increasing incomes of Islamic populations but also in the fact that the basic infrastructureforIslamicfinancehasnowbeenlaidwiththeestablishmentofthe AccountingandAuditingOrganizationforIslamicFinancialInstitutions(AOFFI), and the Islamic accounting standards authority, the Islamic Financial Services Board (IFSB), the international Islamic financial regulatory standardsetting organisation. The Institute for Education in Islamic Finance (ISRA) also provides an invaluable website that is increasingly the transparent source for Sharih interpretationsonwhatisconsideredacceptableunderIslamiclaw(Sheng2011). The Islamic Finance Global Stability Report, which was jointly produced by a number of organisations in 2010, presents a comprehensive overview of the global
financialarchitectureandthecooperationandcollaborationmechanismsamongIFSBmembers needed to promote a competitive, resilient, and stable Islamic finance industry. The Islamic FinancialStabilityForumthatresultedfromthisReport,andtheInternationalIslamicLiquidity Management (IILM), provide Islamic finance with a wider range of tools and instruments, as wellasaroadmapleadingtowardavisionofanintegratedandsoundglobalIslamicfinancial industry.(AhmedandKohli,2011.Pg.xxvii)

With the above empirical background we turn now to the main purpose of this paperwhichistheoreticalandconceptual.ItseekstorelatetheconceptsofIslamic finance to those of conventional finance and to examine certain important economic questions which arise from the interactions between the two kinds of theories. The paper is written selfconsciously from the perspective of conventionaleconomics.Itidentifiessimilaritiesanddissimilaritiesbetweenthese
4

twosystemsofthoughtandspeculatesontheextenttowhichthedifferencescan beresolved.Thecentralconclusionofthepaperisanoptimisticone,namely,that each of the two paradigms of thought has its own strengths and weaknesses but canneverthelesscoexistwiththeotherwithoutanyseriousdifficulties. Therestofthepaperisorganisedasfollows:Thefirstpart,sectionsIIandIIIwill discuss the two fundamental tenets of Islamic finance, namely, (a) absolute prohibitionofinterestpaymentsondebt,and(b)thefundamentalethicalbasisof Islamic law. These will be examined from the perspective of conventional economicstoreachtheconclusionthatalthoughsomeofthestricturesofmodern economics against the Islamic paradigm are inaccurate others are still relevant. Importantly, this part of the paper highlights the moral hazards faced by Islamic depositors as well as by their banks. The analysis of these sections will however indicate that these moral hazard problems apply to both Islamic and nonIslamic financeandthatavoidanceofmoralhazardwoulddependontheeffectivenessof the disciplinarian function of bank risk management, financial regulation, the bankruptcy courts and also the ethics of the key players in each system. Since these may have differences in practice in different countries, it is not possible in principletoarguethatonesystemismoreeffectiveinmoralhazardavoidancethan theother. FromthetwobasictenetsofIslamiceconomicsthesecondpartofthepaperwillgo on to consider in sections IV, V and VI the important relevant tenets of modern economics: (a) the so called Modigliani and Miller (MM) theorems and their implicationsforoptimalcapitalstructureofIslamicbanksandfirms,(b)theroleof the concept of bankruptcy, its costs and who pays the main costs, and their consequences for moral hazard for Islamic and nonIslamic finance and, (c) the efficientmarketshypothesisandthetheoryofstockmarketswiththeirapplication toIslamicinstitutions.Under(c)thepaperwillprovideacriticalbutconstructive analysis of the concept of an Islamic stock market. A concluding section will summarisethemainfindingsofthepaperandprovideabriefconclusion. Toelaboratefurther the paperwillgivespecialattention to thefollowingspecific issues: a. In view of the absolute prohibition in Islamic finance to pay any kind of interestondebt,animportantquestioniswhetherornotitispossibletorun
5

efficiently an economic system which does not have a key role for interest rates? b. What role do interest rates play in conventional economics at a theoretical levelandinpracticalterms?Canothervariablessubstituteforinterestrates inalternativeeconomicsystems? c. Why and to what degree are the households, firms and banks involved in Islamic finance vulnerable to moral hazard? The concept of bankruptcy, its costs for contracting parties under the two systems and their relationship withmoralhazardwillbeanalysed. d. What are the implications of MM theorems for Islamic banks and firms? Is thereanoptimaldebtequityratiofortheseinstitutions? e. What,ifany,shouldbetheroleofthestockmarketinIslamicfinance?Tobe acceptableforthelatter,howwouldtheIslamicstockmarketdifferfromthe conventionalstockmarket? Although this commentary on Islamic concepts is based on modern economic analysis,itfullyacknowledgesthecontributionsofthegreatcontemporaryIslamic economicscholars,includingamongothers, ProfessorsAbbasMirakhor,Mohshin Khan, Ahmed Ali Saddiqui and the eminent late IMF economist Dr. V. Sundararajan.Thispaperbuildsasmuchontheworkofthesescholarsasonthatof conventionaleconomists. II. CENTRAL TENET OF ISLAMIC FINANCE: ABSOLUTE PROHIBITION AGAINST INTEREST RATES Inthe1970swhenthesubjectofIslamicfinancewasfirstraisedinaseriousway,its centraltenetoftheabsoluteprohibitionofinterestpaymentsondebtwasseverely criticised by mainstream economists. It was alleged that such a prohibition was incompatible with modern economic analysis and would result in a gross mis allocationofresources.Itwasdubbedasazerointerestsysteminwhichtherewas noreturn tocapital. Professor Mirakhor(2009)reports that the BBCand theWall Street Journal regarded the system as being totally nonviable and derived from voodooeconomics.
6

Apart from these popular criticisms of Islamic injunctions against any interest payments,therewerealsoseriousacademicobjections.ProfessorMirakhor(2010) summarisesbelowthemainpointsofthesecriticisms: that zero interest meant infinite demand for loanable funds and zero supply; such a system would be incapable of equilibrating demand for and supplyofloanablefunds; withzerointerestratetherewouldbenosavings; thismeantnoinvestmentandnogrowth; inthissystem,therecouldbenomonetarypolicysincenoinstruments of liquidity management could exist without a fixed predetermined rateofinterest;and,finally, thisallmeantthatincountriesadoptingsuchasystemtherewouldbe onewaycapitalflight. Itshouldbenotedthatalltheabovecriticismswouldalsoapplytocountriesthat practiceZeroInterestRatePolicies(ZIRP)underquantitativeeasing. IncontrastwithIslamiceconomicanalysisconventionaleconomistswidelyusethe notion of interest rates in their work. In terms of their paradigm they have legitimate use of zero interest rates, negative interest rates as well as positive interest rates in examining real world economies. To illustrate, about half a century ago, a leading Marxist economist of the time, Maurice Dobb (1960) suggestedthatfromthesocialpointofview,therateofinterest,connotingsocietys time preference, should be zero. Individuals die while society goes on forever. Thereisnoreasontofavouronegenerationoveranother. In a parallel contribution around the same time, Maurice Dobbs pupil A.K.Sen (1962, later to win the Nobel Prize) argued that even though society goes on forever, in a growing economy, there should be time preference for the present whenpeoplearenotsorichastheywouldbeatafuturedate.Thiswouldindicate normallyspeakingarelativelylowpositiveinterestrate(asopposedtoazerorate).

Thatwouldallowarelativelygreaterconsumptiontodayandarelativelysmaller consumptiontomorrowthanwouldotherwisebethecase. In conventional economics the negative interest rates often arise from the governmentsindustrialpolicywherethegovernmentwishestoencouragecertain industriesandisthereforewillingtosocialisetherisksinvolvedfortheindividual firm;inotherwordsthegovernmentsubsidisestherelevantactivitiesofthefirm. Highpositiveinterestratesalsohaveaplaceinconventionaleconomicsanditmay be useful to elaborate on this work in view of its claimed relevance to many developing countries, particularly during the process of financial liberalisation in thesecountriesintherecentdecades.Theobviousreferencehereistothehighly influentialworkinthe1960s,and1970s,andsubsequentlyofthesocalledStanford SchooleconomistsMcKinnon(1973)andShaw(1973).Inaseriesofpapers,written independently, the two economists argued strongly in favour of financial de repression. They suggested that the liberalisation of the financial system would lead to higher interest rates and thereby to greater savings, investments and growth. This work is controversial and its conclusions are contrary to much mainstream economics as well as those of Islamic finance. It will therefore be useful to examine more fully the main assumptions and conclusions of the Stanfordschool.1 The Stanford economists advanced inter alia, the following main propositions concerningtheroleofinterestratesinlongtermeconomicgrowth(McKinnonibid; Shaw ibid; for a classic review of the early literature, see Fry 1988; see also Fry 1997). First, financial deepening through growing financial intermediation and monetization of the economy aids economic development. Secondly, financial repression, whereby in many third world countries the Governments hold the interest rates artificially low and provide subsidized credits either to favoured sectors or to themselves, is inimical to long term economic growth. Thirdly, liberalization of these repressed credit markets will foster development, since raisinginterestratestotheirequilibriumlevelsleadsnotonlytohighersavings butalsotomoreefficientuseofinvestmentresources.

SectionsIIandIVdrawonandupdatethematerialinSinghandHamid(1992)andSingh(1995).SeealsoSingh (1997).
1

All these assertions,particularlythe lasttwo, aredebateablebothat a theoretical level as well as empirically. It is not our purpose here to provide a detailed analysisofthesepropositions.Sufficetosay,verybriefly,thatinthemainstream, the Keynesian economists in particular, contest the McKinnon and Shaw hypotheses on the ground that their underlying model assumes that savings determine investment. Since saving is done by different economic agents (individuals and households), and investment is done by other groups such as firms and entrepreneurs there is no reason why savings should determine investment.CriticsalsopointoutthatMcKinnonandShawassumethereisalways fullemploymentofresources.Moreover,theysuggestthatwhetherornothigher interest rates in the formal sector following liberalization will increase aggregate savings depends on the savings behaviour of the losers and gainers from this process. To the extent that the personal sector finances the investments of the corporate sector, which in developing countries are often highly geared, higher interest rates may reduce corporate profits and retained earnings. The central pointisthat,althoughtheriseininterestrateswillincreasepersonalincomes,ifthe savingspropensityofthepersonalsectorislowerthanthatofthecorporatesector (whichislikely),itwillleadtoafallintotalsavings(Akyuz,1991). More importantly, whether for the above reasons or others, empirical evidence from many countries, particularly Asian countries, which liberalized their credit marketsinthe1980sand1990sandincreasedrealinterestratesdidnotindicatea systematicriseinaggregatesavings.AsChoandKhatkhate(1989)notedintheir influentialanalysisofthefinancialliberalizationexperienceoffiveAsiancountries (Indonesia,Malaysia,Philippines,RepublicofKoreaandSriLanka): Itwasbelievedthattheremovaloftherepressivepolicieswouldboostsaving.Thesurveyin
this paper of the consequences of reforms does not reveal any systematic trend or pattern in regard to saving (and also investment), though it clearly demonstrates that reform has greatly contributed to the financialization of savings. In mostof these countries, savingschanged ina randomfashion.

Akyuz (1991) reached the same conclusion with respect to aggregate savings in relation to Turkeys liberalization experiment during the late 1970s and in the 1980s. Asfortheeffectsofcreditmarketliberalizationontheefficiencyoftheinvestment allocationprocess,leavingasidethedisastrousconsequencesofsuchliberalization
9

intheSouthernConecountriesinthe1970s,manysuccessfuleconomieshaveused subsidiesindeednegativeinterestratesforlongperiodsoftimeasanimportant partoftheirindustrialpoliciesduringthecourseofeconomicdevelopment.This hascertainlybeentrueofJapan,whichprovidednegativerealinterestratestoits favoured corporations for much of the postwar period of its most rapid industrialization(1950to1973).ThusSachs(1985)notesinrelationtoJapan:
Domestic capital markets were highly regulated and completely shut off from world capital markets. The government was the only sector with access to international borrowing and lending. Foreign direct investment was heavily circumscribed, with majority ownership by foreign firms both legallyand administratively barred. During the early to mid1950s,abouta third ofexternal funds forindustrial investment originatedin loans from government financial institutions, at preferential rates that varied across firms and industries. These state financial institutionsremainedanimportantsourceofcheapfinancinguntilthe1960s.

As Amsden (1990) pointed out, subsidies and directed credit were also a central feature of the Republic of Koreas highly successful industrial policy during the previoustwodecades. To sum up there is enough evidence to indicate that, contrary to the Stanford school,ahighinterestratepolicybasedonfinancialderepressionwasapparently notregardedasbeingsuitablebymanydevelopingcountries.Themostsuccessful economiesinEastAsiadidnotfollowsuchpolicies.Policymakersindeveloping countries ordinarily try to maintain low interest rates in order to encourage investmentandgrowth.Inthatsense,thereisunlikelytobemuchdifferenceata practicallevelintheperformanceofIslamicand nonIslamic countriesin the real world.However,ataconceptuallevel,thedifferencebetweenthetwoparadigms is huge. Islamic scholars do not find any justification for positive interest rates. Nevertheless, the fundamental flaw in the mainstream strictures against the zero interestratepolicyofIslamicfinancewasthatitfailedtotakeintoaccountthefact that although the policy did not reward financial investment with interest payments, profits on capital and enterprise were fully allowed, and indeed encouraged. An economic system where the capital is rewarded according to its earning capacity could be entirely adequate for achieving sufficient savings and investments for economic growth, and for allocating them efficiently. The main propositionofIslamicfinanceisthatthereturntocapitalisdeterminedexpostand
10

would be based on the return to economic activity in which the capital was employed. Savings and investment would be determined by this expost rate of returnoncapital.Indeed,subsequentresearchshowedthattheIslamicsystemcan bebasedentirelyonequitycapital,withoutdebt,andisthereforeoftenmorestable than the conventional system based on debt. This question will be discussed further in section IV where the Modigliani and Miller theorems and their implicationsforoptimalfinancialstructureforfirmswillbeanalysed. Thisdiscussionraisesanimportantquestionforconventionaleconomists,whether aneconomicsystemrequiresanexanteinterestratetofunctionefficiently.Here, ProfessorMirakhor(2011)hasremindedusthattheArrowDebreuHahnsystemof generalequilibrium,togetherwithitswelfarepropertiesdoesnothaveanexante interest rate in the analysis. This system is totally viable and is indeed the crowning glory of modern economics. Adding an extra variable such as the interestratewouldoverdeterminethesystemandwillbedifficulttointerpret.See alsoMilgate(forthcoming). Itisalsointerestingtonotethatbecausethereiscompetitionbetweenconventional investorsandinvestorsinIslamicbanksthereisnotlikelytobemuchdifferencein theratesofreturn(interestinthecaseofconventionalbanksandshareofprofitsin thecaseofretailIslamicprofitandlosssharing(PLS)accounts)earnedbythetwo groups.ThishypothesisisconfirmedbyarecentIMFstudywhichcomparesthe rate of return from the two kinds of banking institutions in Malaysiaand Turkey overtheperiodJanuary1997toAugust2010(seeCevikandCharap2011). Thedatarevealed,asexpected,ahighdegreeofcorrelationbetweenconventional depositratesandtherateofreturnonretailPLSaccountsinMalaysiaandTurkey. Between January 1997 and August 2010, a correlation of one year term conventional bank deposit rates and a rate ofreturn for PLS accounts was 91 per centforMalaysiaand92percentforTurkey.Theeconometricresultsshowstrong evidence of cointegration between conventional bank deposit rates and PLS returns over the long term. Granger causality is found between conventional deposit rates and the rate of return on PLS accounts both in levels and first differences.AnimportantresultbasedonpairwiseGrangercausalitytestsindicate thatthenullhypothesisthatchangesinPLSreturnsdonotGrangercausechanges inconventionaldepositratesbothinMalaysiaandTurkeycannotberejected,but the null hypothesis that changes in conventional deposit rates do not Granger
11

causechangesinPLSreturnscanberejected.Theauthorsalsouseerrorcorrection methodologyandfind thatcausalitytestsconfirmthefindingsbasedonpairwise Grangercausalitytests(CevikandCherap,2011). Thus,inbroadtermsanIslamicbankingsystemisanessentiallyequitybased systeminwhichdepositorsaretreatedasiftheyareshareholdersofthebank. Thereisthusnofixedpaymenttothedepositorsfortheirmoneybuttheyare entitledtoashareoftheprofitsofthebank. Inthisequitybasedsystem,corporategovernanceisratherdifferentthanin theconventionalsystem.Itwillbearguedbelowthatthisleadstoproblems ofmoralhazardfortheIslamicbank. ItwillbesuggestedfurtherthattheredistributivestanceofIslamiclawsleads totheproblemsofmoralhazardforthedepositor. Thisrequireseitherstrongethicsorverystrongregulation,orbothforthe resolutionofthesedifficulties. In view of their significance for the theory and empirics of Islamic Finance these pointswillbeexaminedmorefullyinthenextsection. III. ETHICAL FOUNDATIONS OF ISLAMIC FINANCE

Although the rejection of interest payments is an essential element of Islamic finance,thefoundationsofthelatterlieincertainethicalprincipleswhichinturn emanate from Quran Sunnah and legal and ethical reasoning of Sharih scholars. These in their entirety constitute the basis for Islamic finance. Ethical principles guiding Islamic finance include significantly: the avoidance of Gharar: The concept
applies to preventable ambiguity and uncertainty, Ahmed and Kohli (2011, p).

Principles of Islamic finance are implemented through contracts. Sharih law covers conditions of contract and interalia rights and freedoms of the contracting parties. ImportantlythereisastrongredistributiveelementinIslamicfinance.AsProfessor Mirakhor notes in the conventional system, rich help the poor as a demonstration of
sympathy, beneficence, benevolence and charity. In Islam, the more able arerequired to share the consequences of the materialization of idiosyncratic risks illness, bankruptcy, disability, accidents and socioeconomic disadvantaged for those who are unable to provide for
12

themselves. The economically well off are commanded to share risks of those who are economicallyunabletousetheinstrumentsofIslamic finance. In Islamicfinance,therisksthat would face the future generations are shared by the present generation through the rules of inheritance. These rules break up the accumulated wealth as it passes from one generation to anothertoenablesharingrisksofalargernumberofpeople,Mirakhor(2011,p15).

Toillustratewithasimpleexamplefromanelement oftheIslamicbankingcode, consider the case of a mortgagee with an Islamic bank. In Islamic finance the normal mortgage contract carries an implicit and explicit assurance that if the mortgageeisunabletopayhismortgage,thecontractwillentitlehimforhelpfrom theBank. Some economists argue that this will create a moral hazard for the mortgagee. However, opinions differ. Other scholars suggest that if the mortgagee does not obey the Islamic ethical code outlined above he or she will be subject to severe sanctions from members of the community. Similarly Khan and Mirakhor (1993) arguethattheBankshavedirectandindirectcontrolovertheagententrepreneurs throughbothexplicitandimplicitcontracts.Thisisthecasebecausebankscould refuse further credit or blacklist the agententrepreneur and put at stake his/ her credibility and respectability. This brings in a strong deterrent to irresponsible behaviour. However Sundararajan (2011) observes that this argument does not changethefactthatthebankhasnolegalmeanstointerveneinthemanagementof thecurrententerprisewhileitisdonebytheagententrepreneur. To the mainstream economist, it seems very unlikely that adherents of Islamic finance will be able to live up to such high moral standards. Conventional economics invariably assumes that human beings are selfish and analyses their activities on the basis of that postulate. If the same assumption of selfishness is madeinrelationtotheparticipantsinIslamicfinanceitwillleadtoahugemoral hazardproblemonthesideofthedebtor. ThereissimilarlypossibilityofmoralhazardonthesideoftheBank.Thisarises fromtheunrestrictedMudarabacontractwherethebankmanagesthedepositsatits own discretion. This increases the moral hazard for a bank as it may indulge in more risk taking, without adequate capital. As Sundararajan (2011) notes, investment depositors in Islamic Banks do not enjoy the same rights as equity investorsinconventionalinvestmentcompaniesbutdosharethesamerisks.
13

For these reasons, Islamic finance poses considerable pressure on the Islamic Finance management to manage their investment risks to avoid moral hazard. It alsoposesconsiderablepressureonthefinancialregulatorstomonitorinvestment andagency(bankintermediary)behaviourtoavoidpassingallrisksultimatelyto the depositor. A third unknown factor is the certainty of the shariah bankruptcy courtstoenforcedisputesovercontractsthatshowclearsignsofmoralhazard(or shirkingbyborrower/investeetoavoidhisrepayments). Table 1 in the appendix outlines the main differences between Islamic and non Islamic banks. The most recent empirical research by the World Bank economists shows that conventional and Islamic banking are more alike than previously thought. Differences in business models if they exist at all do not show in standard
indicatorsbasedonfinancialstatementsinformation.Otherdifferences,suchascostefficiency, seem to be driven more by country rather than by bank type differences. Finally, the good performanceofIslamicbanksduringtherecentcrisisappearstobedrivenbyhigherprecaution in liquidity holdings an capitalization, but no inherent difference in asset quality between the twobanktypes,Beck,Kunt&Merrouche(2010).Althoughbasedonratherdifferent

data and a different definition of the analytical problem, the World Bank economistsconclusionsfromtheirempiricalstudysupporttheconclusionsofthe IMFeconomists,CevikandCherap,asdiscussedintheprevioussection. AlthoughasnotedinsectionI,Islamicfinancehasexpandedveryfast,itstillhasa small share of world finance and is still in a niche market Tan (2009). Some respected commentators argue that the market has concentrated on the development of safe, shortterm financial instruments and ignored the longterm market. It is feared by these scholars that because of path dependency which is characterised by many economic events, the Islamic finance industry may simply continuetooperateontheshortendofthemarket.Indeed,thesewellwishersof Islamic finance would like to take a major step forward and develop an Islamic stock market for meeting the needs of the Islamic investors for investments with longtermhorizons.Thisimportantquestionwillbeexaminedindetailinsection V. IV. MODIGLIANI AND MILLER THEOREMS HavingexaminedthetwobasictenetsofIslamicfinanceweshallnowmoveonin thesecondpartofthepapertoconsiderafundamentaltenetofmoderneconomics, namely the so called Modigliani and Miller (MM) Theorems concerning the
14

optimal financial structure of firms. We shall also analyse the feasibility and desirability of establishing stock markets on Islamic rules to assist the growth of Islamicfinance. Sincethelate1950sanduntilrecently,themodernneoclassicalviewoffinancehas beendominatedbythesocalledirrelevancetheoremsassociatedwithModigliani and Miller (1958, 1961). In seminal contributions, starting with their pioneering 1958paper,ModiglianiandMillerputforwardtwocentralpropositionsaboutthe theory of finance. They showed that in fully developed capital markets, under fully idealised neoclassical assumptions of perfect competition, no transaction costs, no taxation and no bankruptcy, even in a world of uncertainty, the stock market valuation of the firm is independent of its financing or dividend payout decisions. On the basis of certain further restrictive assumptions about expectationsandthenatureofuncertainty(e.g.uniformityinexpectationsheldby allinvestorsonthestockmarket),itwasestablishedthatthemarketwouldvalue thefirmssharesentirelyonthebasisofitsearningsprospects;sharepriceswould beinvarianttothecapitalstructureofthefirmortotheextenttowhichitresortsto internalorexternalsourcestofinanceitsinvestmentplans. Miller(1991)providesanintuitiveexplanationfortheMMtheoremswiththehelp ofananalogy.Thinkofthefirmasagigantictubofwholemilk.Thefarmercansellthewhole
milkasitis.Orhecanseparateoutthecream,andsellitataconsiderablyhigherpricethanthe whole milk would bring. The ModiglianiMiller proposition says that if there were no costs of separation,(and,ofcourse,nogovernmentdairysupportprogramme),thecreamplustheskim milk would bring the same price as the whole milk. Vallimil further elaborates on this

explanationinthefollowingterms:theessenceoftheargument isthatincreasingthe
amountofdebt(cream)lowersthevalueofoutstandingequity(skimmilk)sellingofsafecash flowstodebtholdersleavesthefirmwithmorelowervaluedequity,keepingthetotalvalueon thefirmunchanged.Putdifferently,anygainfromusingmoreofwhatmightseemtobecheaper debt is offset by the higher cost of now riskier equity. Hence, given a fixed amount of total capital, the allocation of capital between debt and equity is irrelevant because the weighted average of the two costs of capital to the firm is the same for all possible combinations of the two.

At a deeper level, the Modigliani and Miller theorems suggested a dichotomy betweenfinanceandtherealeconomy:corporategrowthandinvestmentdecisions were dictated completely by real variables such as productivity, demand for output,technicalprogressandrelativefactorpricesofcapitalandlabour.Finance
15

in this paradigm is always permissive and simply facilitates the investment process. Asinthecaseofneoclassicaleconomics,thenormalKeynesianperspectiveonthe role of finance in investment and economic growth also assumes welldeveloped capital markets. However, this perspective does not postulate perfect capital markets in the sense that the relevant information on costs, reliability and other aspectsofthetransaction,isnotavailableonequaltermstoalltheparticipantsin themarket.AccordingtotheKeynesianview,corporateinvestmentisessentially determinedbyanimalspirits,bybusinessmensconfidence,byexpecteddemand and by the cost of capital. The latter variable in practice is regarded as being relativelyinsignificantcomparedwithdemandfactors. As they do not accept the assumption of perfect capital markets, Keynesian economists do not generally believe that the Modigliani and Miller propositions areoperationalintherealworld.Theseneoclassicalirrelevancetheoremsalsorun contrary to the traditional conception of a firms investment and financing decisions. The traditional view was a socalled pecking order theory of finance (Donaldson, 1961; Myers, 1984 and 1985; Fazzari, Hubbard and Peterson, 1988), which suggested that firms always preferred internal to external finance and, if theyhadtouseexternalfinance,theywouldprefertoemploydebtandonlyasa last resort, equity finance. The firms capital structure and its dividend payout decisions, in this analysis, were important variables which had an independent influenceonitsshareprice.Moregenerally,thenonavailabilityoftheappropriate kind of finance could constrain a firms growth or investment plans: this suggestion was often incorporated in the postwar microeconomic investment models in the Keynesian spirit. Mayer and Kuh (1957) and Mayer and Glauber (1964)areclassicreferences.TheseissueshavebeencarefullyexaminedinStiglitz (1998and2005). Paradoxically, the above traditional theory of finance has been resurrected and revalidatedbyanumberoftheoreticaldevelopmentsinthelasttwodecadeswhich attempttorelaxsomeofthehighlyrestrictiveassumptionsoftheModiglianiand Miller propositions. With respect to the latter, it was noted at the simplest level thatiftaxationandpossibilityofbankruptcyandfinancialdistressareintroduced intotheanalysis,thiswouldproduceanoptimalcapitalstructureforthefirmand thus invalidate the ModiglianiMiller irrelevance theorems. Many corporate tax
16

systems, for example, allow interest to be deducted as costs, which provides a significanttaxadvantageintheuseofdebtfinance.Thereis,however,atradeoff, sincetoohighalevelofdebtincreasestherisksofbankruptcyorfinancialdistress inaneconomicdownturn.Thissimpletradeoffmodelleadstoanoptimaldebt equityratioforthefirm,whichmaximizesitsstockmarketvaluation. Morecomplexconsiderationsandtheoreticaldevelopmentsinvolvingasymmetric informationbetweeninsiders(managers)andoutsiders(creditorsorshareholders), problems of adverse selection, moral hazard, agency costs, signalling and transactioncostsleadtodifferentcostsofthevariousformsoffinanceandcanbe shown to be broadly compatible with the pecking order type theory outlined above (The classic reference here is Myers and Majluf, 1984). In general, this far richer and more complete analysis of the issues points to the significance of the corporate capital structures and the financial decisions for the real economy. At theveryleast,thenewmodelsofthefirmsuggestthatfinanceisnotsimplyaveil, but that there are very important interactions between corporate finance and the realeconomy.Thus,unliketheneoclassicalinvestmentmodels(seeinparticular the widely acknowledged and valued contributions by Jorgensen and his colleagues) which dominated the profession in the 1960s and 1970s, many economists subsequently in the light of the new interpretation of MM Theorems, particularly the postKeynesian ones, came to regard cashflow and corporate retainedearningsasbeingasignificantconstraintonafirmsinvestmentdecisions. Howeverourmainconcerninthispaperisnotsomuchwithcorporateinvestment decisions, but with the question of the financial structures of Islamic and non Islamic firms. Stiglitz (1988) has observed that under very general conditions if thereisnochanceofbankruptcythenfinancialpolicyhasnoeffectonthevalueof thefirm;thereisnooptimaldebtequityratio.Thissuggeststhatundertheneo classicalassumptionsofMMTheorems,anyfinancialstructureforIslamicfirmsis optimal, including that of all equity and no debt. However, if these strict assumptionsarerelaxed,particularlywhenthereisarealpossibilityofbankruptcy, thefirmvaluationwilldependonitsdebtequityratio.Thus,foranyspecificfirm there will be a corresponding optimal debtequity ratio. There is no reason to believethatIslamicfirmswouldattempttoachieveorwouldhaveachievedtheir respective optimum financial structures in terms of debtequity ratios. Does this make Islamic firms less efficient? The answer is not necessarily so because the
17

question of optimality in the above analysis is considered only from the perspectiveofanindividualfirmandnotfromthatofsocietyasawhole.Suppose all Islamic firms are 100% equity financed. This may violate the results of the optimality tests of the MM Theorems, but from the point of view of society as a whole such a capital structure may have considerable macroeconomic benefits, suchasmorestableGDPgrowth. ThefundamentalpointisthatifallIslamicFinancecontractsareequitycontracts, thenitisvitalforthebankstoensurethattheinvestee/borrowerisnottoohighly leveraged.Thehighertheleverageoftheborrower,thehighertherisksassumed bytheIFinvestor.Bydefinition,thelowertheleverageoftheborrower,thesafer thefinancialsystemisonthewhole. V. RISK SHARING, RISK SHIFTING AND COSTS OF BANKRUPTCY Fromtheperspectiveofconventionaleconomics,thereishoweveranotherwayof interpreting the differences between the Islamic (IF) and nonIslamic borrowing individualsandfirmsaswellasthelendingbanks.Thisinvolvesthequestionof therelativecostsandefficacyofbankruptcyinthetwosystems.Soitisnotjusta matterofwhetherornotthereisprovisionforbankruptcyorinsolvencyinamodel ofcorporatefinancebutwhatareitscostsandwhoisexpectedtobearthem,inlaw andinpractice. In terms of conventional finance, the real issues are those of information asymmetry, principalagent (contract) and insolvency. Conventional finance assumesthatyoucanshifttherisksbetweentwopartiesbaseduponcontract.In Islamic Finance, one starts with risksharing between the borrower and the bank. Butinallcontracts,thereisaninherentinformationasymmetrywhentheborrower or investee does not know when they will enter economic insolvency (this being dependent on whether banks are willing to lend and the rate of interest). Most companies that are in trouble may be accountingwise still solvent, but economically insolvent, depending on the marktomarket price of assets, which alsodependsontherateofdiscount.Inotherwords,thecompanymaynotknow (andneitherdoestheIslamicFinanceinstitutionknow),whenitbecomesinsolvent. When the company becomes insolvent, the losses are automatically shared amongstitsshareholdersandholdersofitsobligations.
18

Hence, there is essentially no difference between the nonIslamic finance lender andIslamicequitycontractintheserespects.Theconventionallenderprotectshis own risks and shifts these by contracting with the borrower, to include collateral and guarantees. If however, the real interest rate rises, the DCF value of the borrowersassetsdeclineandrealvalueofliabilitiesincreaseandhemaygointo economic insolvency. At the same time, the collateral value of the lenders holdingsofcollateralalsodeclines,(especiallyiftheyarelandorequity).Thus,at higher real rates of interest, especially during a crisis, the borrower moves into economic insolvency and therefore (nontransparently) transfers the insolvency risktothelendersandholdersofhispaper.Thisriskreversionisidenticalinform forIFornonIFfirms. There is a further cost of bankruptcy (transactions cost in time, legal fees etc.) whichtheborrowerorinvestormayhavetoinvestinsoastorecouptheirloanor investment.Thus,ifbothIFandnonIFcontractsinvolveinvoluntaryrisksharing, then the only real distinguishing feature between the two systems is whether the bankruptcylawsarestrongenoughandefficientenoughforenforcement. In the IF contract, there is a moral or nontemporal sanction on the borrower, hoping that this soft power will be more effective than hard power legal or other means of enforcementto force the borrower to repay. The reason is that there is information asymmetry between the borrowers true solvency and the lender/investor.Theborrowermayengageinlyingorhidinghistruesolvencyin ordertopassasmuchlossesaspossibletothelenderand/orinvestor.Wecannot judgeaprioriwhetherIFssoftpowerisnecessarilybetterthanthelegalpowerof debtenforcement.Thisdependsonthecircumstancesofthecase,thelegalpowers inacountry,andtheeffectivenessofthecourtsetc. Toputitclearly,alldebtorrisksharingcontractssufferfrommoralhazard.Ifthey arenotenforcedagainstcheatingorfreeriding,thenriskswillpasstothesolvency holder/lender.Insimpleutilityterms,whenthemarginalbenefittotheborrower ishigherthanthecostofsanctions,thenhewillnotpay.Animportantquestionis therefore whether sanctions are real enough for the borrowers to make the necessary adjustments so that if they cannot pay today, they shall at least pay tomorrow. Itisarguablethatthecostsofbankruptcytotheborrowersintermsofconventional financearelowerfortheIFborrowerthanforthenonIFborrower.Inthecaseof the latter there are not only the laws relating to bankruptcy but also daily court judgementsimplementingthelaw.Thiswilltendtomaketheloancontractmore
19

transparent and probably more painful in case of default. It is worth noting that the basic laws on bankruptcy differ greatly between advanced countries, notably theUSandtheUK.InbroadtermstheUKlawislessuserfriendlytotheborrower than the US law which has the Chapter 13 provisions for allowing the firm to continueasagoingconcernforalongerperiodthanwouldnormallybepermitted byEnglishreceivershiparrangements.Itmayalsobeobservedthatbecauseofthe novelty of Islamic finance there may be nonuniform implementation of the bankruptcylawsforIslamicfirms.Itisnotclearhowmanycasesofbankruptcyin Shariah law are ever settled by Shariah courts. It is also not clear whether the judgementsofthesecourtsareacceptedmoregenerallybythepublicandbynon Islamiccourts. The conclusion of this section is that whether IF or nonIF is more effective in avoidingmoralhazardwoulddependonthewholefinancialinfrastructureofrisk management systems, regulatory systems and the court systems. If Islamic Financial systems end up with lower debt/equity as a whole than nonIslamic systems, then the IF system is likely to be able to cushion shocks as a whole, but thisisaquestionofpractice,notoneoftheory. VI. THE ROLE OF THE ISLAMIC STOCK MARKET

Islamic economists greatly favour the establishment of a stock market based on Islamic principles in order to further the expansion of Islamic finance. Long ago ProfessorMetwally(1984)observed: InanIslamiceconomywhereinterestbearingloans
areprohibitedandwheredirectparticipationinbusinessenterprise,withitsattendantrisksand profit sharing, is encouraged, the existence of a wellfunctioning Stock Exchange is very important.Itwouldallowforthemobilizationofsavingsforinvestmentandprovidemeansfor liquidity to individual shareholders. However, existing Stock Exchanges in nonIslamic economieshavemanydrawbacks.Theygeneratepracticessuchasspeculationandfluctuations insharepriceswhicharenotrelatedtotheeconomicperformanceofenterprises.Thesepractices areinconsistentwiththeteachingsofIslam.

Very recently, one of the foremost scholars of Islamic finance, Professor Abbas Mirakhor(2011),hasarguedforgovernmentinterventiontodevelopavibrantand activestockmarketinIslamicfinancecountries.This,hesuggests,canbejustified on many grounds, but, importantly, empirical evidence has shown a strong and robust
relationship between financial development, including an active stock market and economic
20

growth.Hegoesontoobservethat..arguably,thestockmarketisthefirstbestinstrument ofrisksharing.Developinganactiveandefficientstockmarketcanpromoteinternationalaswell asdomesticrisksharingwhichrendertheeconomyanditsfinancialsystemresilienttoshocks.

It is appropriate to start this analysis with a discussion of these issues in conventionaleconomics.Theadvantagesanddisadvantagesofthestockmarkets havelongbeenthesubject ofacutecontroversyinmainstreameconomics.Inthe first instance, we will briefly review this debate and draw its implications for Islamicfinance. In conventionaleconomics, John MaynardKeynes (1936)wastheleading critic of the stock market. He likened it to a gambling casino and warned that people shouldnotbesurprisedbyunfavourableoutcomesiftheinvestmentdecisionsofa nation are left to the vagaries of a casino. In contrast, like the Islamic scholars above,themainstreamexponentsofthestockmarketbelievethatitcontributesto developmentthroughavarietyofchannels.Itcouldraisesavingsandinvestment by making it possible for individuals and households to purchase a fraction of a shipyardorasteelmill,therebyspreadingtherisk,withoutwhichinvestmentmay not occur at all. Similarly the monitoring function performed automatically and fromtheperspectiveofanentrepreneur,costlessly,bythestockmarketalsohelps raiseinvestment.Moreover,awellfunctioningstockmarketpurportedlyallocates resourcesmoreefficientlythroughitsnormalpricingprocess,whichwouldaccord, otherthingsbeingequal,highersharepricestoefficientfirmsandlowerpricesto inefficientones.Furthermore,thetakeovermechanismostensiblyensuresthatnot just the new investment resources but also the existing capital stock is efficiently utilised. Inefficient use of existing resources is punished by the market for corporate control through disciplinary takeovers.2 The other punishment is through bankruptcy and exit, which also carries with it the shame (sanction) associatedwithbankruptcy. How effectively the stock market can perform the above tasks depends on the efficiencyofthreecriticalmarketmechanisms,namely(a)thepricingmechanisms (b) the takeover mechanism and (c) the exit/bankruptcy mechanism. These are central issues of debate on which there is a voluminous literature, which is outlinedbelow.

SeefurtherSingh(1992and2008)andtherelevantliteraturecitedinthesepublications.

21

The orthodox paradigm of share price determination postulates that share prices are efficient because they emanate from perfect markets involving large numbers ofwellinformedbuyersandsellersinwhichnoonebuyerorsellercaninfluence the price and where there is a homogeneous product, namely shares. There is, however, an alternative paradigm indicated by the passage from Keynes cited earlierthatcharacterizesstockmarketsessentiallyasgamblingcasinosdominated by speculators. Allen and Gale (2000); Shiller (2000); Shleifer (2000); Singh et al (2005),BakerandWurgler(2007);HongandStein(2007)andnotleaststudentsof behaviouralfinance[seeforexampleBarberisand Thaler(2003);Hongetal(2007) and Baker et al (2007)] formalize the various elements of this paradigm. In brief, thisliteraturesuggeststhat,inthefaceofahighlyuncertainfuture,sharepricesare likely to be influenced by the socalled noisetraders, and by whims, fads and contagion. For similar reasons of psychology, investors may attribute much greater weight to nearterm price forecasts rather than historical longterm performance. This line of reasoning is taken further in the growing literature on behaviouralfinance. Untilrecently,theempiricalliteratureonsharepriceshasbeendominatedbythe socalledefficientmarketshypothesis(EMH),whicharguesthatrealworldshare prices are efficient in the sense that they incorporate all available information (Fama,1970).Inthe1980sand1990s,with(a)the1987USstockmarketcrash,(b) the meltdown in the Asian stock markets in the 1990s and (c) the bursting of the technology stocks bubble in 2000, the EMH has suffered fundamental setbacks. Alan Greenspan (1998) has commented as follows on the reasons for (a) and (b): At one point the economic system appears stable, the next it behaves as though a dam has
reached a breaking point, and water (read confidence) evacuates the reservoir. The United States experienced such a sudden change with the decline in stock prices of more than 20 per cent on October 19, 1987. There is no credible scenario that can readily explain so abrupt a change in the fundamentals of longterm valuations on that one day. Kindleberger (1989)

similarly documented about thirty cases of unwarranted euphoria and excessive pessimism on the stock markets since the SouthSea bubble of 1720. He termed theseepisodesasmanias,panicsandcrashes. James Tobin (1984) made an analytically useful distinction between two kinds of efficiencyofstockmarkets,(a)theinformationarbitrageefficiencythatensuresthat all information concerning a firms shares immediately percolates to all stock
22

marketparticipants,ensuringthatnoparticipantcanmakeaprofitonsuchpublic information; (b) fundamental valuation efficiency, that is, share prices accurately reflect a firms fundamentals, namely the long term expected profitability. The growing consensus view is that, in these terms, stock markets may at best be regarded as being efficient in the sense of (a) but far from being efficient in the economically more important sense (b). Thus EMH, as identified in (a), is compatible with share prices not reflecting fundamental values. A more detailed discussionaswellasotherexamplesofsharepricesevidentlydepartingfromtheir fundamentalsisprovidedinSinghetal(2005). Apart from the normal mispricing, which is particularly likely to be severe in developingcountriesastheirfirmsdonothavealongtrackrecord,sharepricesin developing countries are more volatile than in advanced countries [see further Singh (1997); ElErian and Kumar (1995)]. Share price volatility is however a negativefeatureofstockmarketsforseveralreasons.First,itreducestheefficiency of the price signals in allocating investment resources. Secondly, it increases the riskiness of investments and may discourage riskaverse corporations from financing their growth by equity issues and indeed from seeking a stock market listing at all. Thirdly, at the macroeconomic level, a highly volatile stock market mayleadtofinancialfragilityforthewholeeconomy(Singh1997). We now take up the belief of Islamic scholars that the development of the stock market would lead to faster economic growth and faster growth of employment and consumption. This is a variant of what Singh (2008) has termed the World Banks natural progressionargument. TheWorldBankwhich naturally supports the establishment of, and encouragement of stock markets throughout the world, basicallyarguesthatthestockmarketistheemblemofdevelopmentofacountry. As a country develops, it tends to establish stock markets. Stock markets can, therefore, be regarded as an insignia of economic development. Unfortunately, economichistoryisnotcompatiblewiththisinterpretation. Two kinds of evidence are relevant here. The first is the observation that of the economicmiracleswhichhaveoccurredinthesecondhalfofthetwentiethcentury, hardlyanycanbeascribedtostockmarketdevelopment.Thus,inpostWorldWar IIEuropetheItalianmiracle(veryfastgrowth),theGermanmiracle,theAustrian miracleandinAsia,thejustlyfamousmiraclesofKoreaorTaiwan,didnotdepend conspicuously on the equity or bond markets in these countries. Similarly, the
23

second kind of evidence relevant here consists of an examination of comparative growth rates over a longer one hundred years time span. Such an examination reveals that the bankbased countries (for example Germany and Japan) have as good if not a better longterm record of economic growth than the US and UK. Pagano(1993),notesthattheItalianstockmarketwasbiggerahundredyearsago, than it was in 1990. The Italian economy evidently grew during these hundred yearswithoutanyexpansionofthestockmarket.3 It is important, in this context for Islamic scholars to also bear in mind that the stock market often spontaneously leads to the development of a market for corporate control and this market is regarded by traditional economics as the evolutionaryendpointofstockmarketdevelopment.Evidence,however,isallto thecontrary.Researchshowsthatthetakeovermechanismasitworksinthereal world is highly flawed. Selection in the market for corporate control takes place not on the basis of performance alone, but, both on performance as well as size. Thus, a large relatively unprofitable firm has a greater chance of survival than a smallprofitablefirm.Thishasadverseconsequencesforeconomicefficiency.See furtherTichy(2002),Scherer(2006),Singh(2008).Themarketforcorporatecontrol insteadofbeingavehicleforeconomicefficiency,exacerbatestheshortcomingsof stock market by encouraging speculative takeovers of whole companies rather than just buying and selling of few shares of individual companies. Thus, in conventional economic terms, neither the pricing mechanism nor the takeover mechanismintherealworld,arehelpfultoeconomicefficiencyanddevelopment. Thethirdissueistheeffectivenessoftheexitmechanismforfailedcompanies,such as delisting from the stock market or actual bankruptcy. The important disciplinarianroleoftheexitmechanismisthatfailedinstitutionsshouldexitand thatthereareconsequencesforfailure.Manyemergingmarketstockmarketsdo not work well because of the lack of enforcement of rules or allowing more delisting and bankruptcy of failed companies. Indeed, in a number of cases, governmentshavebeenknowntointerveneinstockmarketstobailoutcompanies introuble.Suchactiononlyengendersmoremoralhazardproblems,erodingthe disciplinaryroleoffinancialmarkets.

Apart from this broad brush evidence on the merits of the stock market for economic growth, there are also a numberofeconometricstudieswhichreportmixedresults.Thesestudiesareoftenbasedonreducedformequations wheretheresultsaredifficulttointerpretintermsofcausation.SeeSingh(2008);Levine(1997).

24

Fromtheexperienceofrealworldstockmarkets,itisdifficulttoseeapriorihow such an institution would positively benefit Islamic finance, without stringent supervisory,corporategovernanceandexitmechanismsinplace. VII. SUMMARY OF THE MAIN FINDINGS AND CONCLUSION AsthisessayhasrangedoverseveralfieldsofconventionalandIslamiceconomics, it will be useful to summarise the main theoretical and empirical findings. The paperhasfirstexaminedthecentraltenetsofIslamicfinancefromtheperspective of conventional economic analysis. It started with the question of absolute prohibition of interest payments in any form under Islamic finance. The main conclusion is that it is possible to run an efficient economic system of the Islamic kind, which has no interest payments, but which allows profits on capital and enterprise.Suchasystem,basedtotallyonequityfinanceiscompletelyviableand may,infact,bemorestablethanapartdebtfinancedconventionalsystem. Conventional economics legitimately uses interest rates zero, negative and positiveratesforitsanalysisofrelevanteconomicconditions.Thereis,however, little evidence to support the McKinnon and Shaw hypotheses that financial liberalisation necessarily leads to high interest rates which in turn generate high savings, investments and economic growth. The highly successful East Asian countriesemployedlow,evennegative,ratesratherthanhighinterestratesduring theirindustrialisation. As developing country policy makers are prone to use low but positive interest ratesinordertoencourageinvestmentandgrowththereis,inpracticalterms,very littledifferencebetweenconventionalandIslamic(zerointerestrate)paradigmsin their practical applications. The rates of return on deposits in conventional banks andthoseofprofitsharingaccountsinIslamicfinancetendtobehighlycorrelated andbroadlyofsimilarmagnitude. AnanalysisofthesecondmajortenetofIslamicfinance,namely,itsethicalsystem indicates that if human beings strictly adhere to the requirements of the Islamic ethics there would be few moral hazard problems in Islamic banking. However, sincetotaladherencetotheIslamicethicalsystemisunlikelyformostindividuals, importantmoralhazardissues,bothonthesideofthedepositorsinIslamicbanks
25

aswellasonthesideoftheIslamicbankthemselvesloomlarge.Thesewouldneed toberesolvedintherealworldbyextensiveregulation.Itisamootpointwhether such far reaching regulation of individual ethical behaviour is at all feasible or desirable. Turning to the relevant chief tenets of conventional economics we first find that there is no straight forward application of Modigliani and Miller theorems to Islamic firms and banks. This is because the assumptions underlying these theoremsofnotransactionscosts,perfectmarkets,notaxationandnobankruptcy, depart considerably from the real world situations. If these assumptions are relaxedtoconform more to therealworldthenonewouldgetan optimalcapital structure,i.e.someparticulardebtequityratioforaspecificfirm.However,thisis optimalityfromthepointofviewofthefirmratherthanthepointofviewofthe societyasawhole,soitwillbedifficulttoreachthejudgementthatIslamicfirms havenonoptimalcapitalstructuresonthebasisofModiglianiandMillertheorems alone. Although for MM theorems, the concept of bankruptcy is important, in the real world, it is its costs and who pays these which are significant factors in distinguishing between the two systems. The real issues are information asymmetry, the principalagent (contract) and insolvency costs, and whether or not, the operation of these concepts leads to a hard budget or a soft budget constraint for the borrowing firms which do not wish to pay and to shift the burdentothelender.IntheIslamicfinancecontractthereisanadditionalimplicit sanction against this type of moral hazard of the borrower which may be called softpower.Thismaybeinsomeinstancesmoreeffectivethanthehardpower ofthebankruptcylawsbutitisdifficulttoimaginethatitwilldosoeverytimeor inmostcases. The paper considers the desirability of establishing stock markets to further the completion of the Islamic finance programme and to help with its expansion. It providescriticalbutconstructivecommentsonthisimportantproposal.Thepaper suggeststhatbecauseitisimpossibletodistinguishbetweenspeculativeandnon speculativeinvestmentstrategiesitwouldbedifficulttoestablishintherealworld astockmarketwithIslamicethicsinwhichnonspeculativestrategiesarefollowed byallplayers.Thepaperalsofoundthatitisnotcorrecttosaythathistoricallythe stockmarkethasplayedakeyroleineconomicdevelopmenteitherintheperiodof
26

fast growth of the world economy since the Second World War or over a longer period comprising the last hundred years. In countries like Japan and Germany, banks rather than the stock market have played the pivotal role in economic development.InthepostWorldWarIIperiod,theGermanmiracle(ie.historically fastgrowth),theItalianmiracle,theAustrianmiracleandinEastAsiatheKorean, the Japanese and the Taiwanese miracles were not conspicuously aided by the stockmarket.InGermany,untilabouttwodecadesagotherewereonly650firms listed on the stock market of which only 25 were actively traded. Similarly, in setting up their economic system after the Second World War, the Japanese deliberately favoured the development of the main bank system rather than the stockmarket(Singh1995,2008).Thepaperdrawsattentiontootherdrawbacksof thestockmarketsandtheassociatedmarketforcorporatecontrolwhichwillnotbe helpfulforanIslamiceconomy. In conclusion, a conventional stock market would not be useful for Islamic economies but a Shariah compliant stock market without speculative players may bedifficulttoorganise.Yet,thesearchforanethicalstockmarketmustcontinue. To sum up and to conclude briefly, the two systems, the Islamic and the conventional have existed side by side for the last two or three decades without any serious conflict. The conventional system, if anything, has helped the development of Islamic finance. As Islamic finance becomes stronger, there may be room for conflict but it is not inevitable. Cooperation between these two systemsiseminentlydesirableandfeasible.TheconventionalandIslamicfinance maycooperateorevencompetetoproducethebestoutcomeforcommonprojects such as the provision of cheap banking for the worlds poor or for investment in environmentalundertakings.Thereareareasinwideningaccesstofinancewhich may be more desirable under Islamic finance because of the ethical basis of funding. It is arguable that conventional finance, because of its use of debt, is likelytohaveafaster,butmoreunstable,growththanIslamicfinance.Thuseach systemhasitsstrengthsandweaknessesandonecaneasilycoexistwiththeother tothebenefitofhumankind.
27

Table I: A Comparison between Islamic and Conventional Banking

Features Guaranteeofthecapital Valueof: Demanddeposits Investmentdeposits Rateofreturnondeposits Mechanismtoregulate Finalreturnsondeposits Profitlossprofit(PLS) principleapplies UseofIslamicmodesof financing: PLSandnonPLSmodes Useofdiscretionby bankswith regardtocollateral

Islamicbanking Yes No Uncertain,notguaranteed forinvestmentdeposits. demanddepositsare neverremunerated. Dependingonbank performance/profitsfrom investment. Yes Yes Generallynotallowedto reducecreditriskinPLS modes.Bywayof exception,maybeallowed tolessenmoral hazardinPLSmodes. AllowedinnonPLS modes.

Conventionalbanking Yes Yes Certainand guaranteed. Irrespectiveofbank performance/profits frominvestment. No Notapplicable. Yes,always

Source:IslamicFinance:WritingofV.Sundararajan,Eds.J.AhmedandH.S.Kohli,2011.

28

REFERENCES Ahmed,JaseemandHarinderS.Kohli(2011)IslamicFinance:Writingsof V.Sundararajan,Ahmed,JandH.S.Kohli(eds.),SagePublicationsIndiaPvt.Ltd., India,2011. Akyuz,Yilmaz(1991)FinancialLiberalisationinDevelopingCountries:ANeo KeynesianApproach,UNCTADDiscussionPaper36,March1991. Amsden,AliceH.(1990)WhyIsnttheWholeWorldExperimentingwiththeEast Asianmodeltodevelop:ReviewoftheEastAsianMiracle,WorldDevelopmentVol. 22,Issue4pp.627633. Barberis,NicholasandThaler,RichardH.(2003)ASurveyofBehavioralFinance,in HandbookoftheEconomicsofFinance,GerogeM.Constantinides,MiltonHarris,and ReneStultzeditors.ElsevierScience,NorthHolland,Amsterdam. Beck,Thorsten,AsliDemirgucKuntandOuardaMerrouche(2010)Islamicvs. ConventionalBanking:BusinessModel,EfficiencyandStability,TheWorldBank PolicyResearchPapers,WorkingPaperNo.5446,October2010. Brown,Kevin(2011)AsiaPacific:SingaporeLaunchRaisesProfileintheRegion, FinancialTimes,May11,2011. Cevik,SerhanandCharap,Joshua(2011)TheBehaviorofConventionalandIslamic BankDepositReturnsinMalaysiaandTurkey,IMFWorkingPaperWP/11/56,July 2011. Chang,HaJoon(2000)TheHazardofMoralHazard:UntanglingtheAsian Crisis,WorldDevelopment,Vol.28,No.4,pp.775788. Cho,YJ.andD.Khatkhate(1989)LessonsofFinancialLiberalizationinAsia:A ComparativeStudy,WorldBankDiscussionPaperNo.50. Deakin, S. and Singh, A. (2008) The Stock Market, the Market for Corporate Control andtheTheoryoftheFirm:LegalandEconomicPerspectivesandImplicationsforPublic
29

Policy,CambridgeUniversityCBRWorkingPaperNo.365.Publishedsubsequently in a revised form in Bjuggren, P., and Mueller, D.C., (eds.) The Modern Firm, CorporateGovernanceandInvestmentElgarPublications,2009.pp:185222. Dobb,MauriceH.(1960)EssayonEconomicGrowthandPlanning,LawBook CompanyofAustralasia,Pyrmont,Australia,1960. Donaldson,G.(1961)CorporateDebtCapacity,HarvardUniversityPress,Boston, Massachusetts. Eaton,Jonathan,MarkGersovitzandJosephE.Stiglitz(1986)ThePureTheoryof CountryRisk,EuropeanEconomicReview,Vol.30,pp.481513. ElErian,M.andM.Kumar(1995)EmergingEquityMarketsinMiddleEastern Countries,IMFStaffPaperNo.32,pp.313343.AlsopublishedinDevelopmentinthe FinancialMarketsinArabCountries,IranandTurkey,IDRCProjectPublications, EconomicResearchForumoftheArabCountries,IranandTurkey,Egypt,1995, pp.129175. Fama,E.(1970)EfficientCapitalMarkets:AReviewofTheoryandEmpirical Work,JournalofFinance,Vol.25,pp.383417 Fazzari,S.M.,R.G.HubbardandB.C.Peterson(1988)FinancingConstraintsand CorporateInvestment,BrookingsPaperonEconomicActivity,1. Fazzari,S.M.andB.C.Peterson(1993)InvestmentSmoothingwithWorking Capital:NewevidenceontheImpactofFinancialConstraints,RANDJournalof Economics,Vol.24,Issue3,Autumn,pp.328342. Fry,MaxwellJ.(1988)Money,InterestandBankinginEconomicDevelopment, Baltimore,JohnHopkinsUniversityPress. Fry,MaxwellJ.(1997)InFavourofFinancialLiberalisation,EconomicJournal,Vol. 107,Issue442,pp.754770. Hellmann,ThomasandJosephE.Stiglitz(1998)CreditandEquityRationingin MarketswithAdverseSelection,EuropeanEconomicReview. Hong,H.andStein,J.C.(2007)DisagreementandtheStockMarket,TheJournalof EconomicPerspectives,Spring2007,Volume21,No.2,pp.109128
30

Khan,MohsinS.andAbbasMirakhor(1992)IslamandtheEconomicSystem, ReviewofIslamicEconomics,Volume2,No.1,1992,pp.129. Khan,MohsinS.andAbbasMirakhor(1994)MonetaryManagementinanIslamic Economy,JournalofKAU:IslamicEconomics,Vol.6,pp.321. Khan,MohsinS.andAbbasMirakhor(1989)TheFinancialSystemandMonetary PolicyinanIslamicEconomy,JournalKAU:IslamicEconomics,Vol.1,pp.3957. Kindleberger,C.P.(1989)Manias,Panics,andCrashes:AHistoryofFinancialCrises, NewYork:BasicBooks,1978,revised1989. Kuh,E.(1963)CapitalStockGrowth:AMicroeconometricApproach,Amsterdam. Levine,R.(1997)FinancialDevelopmentandEconomicGrowth:Viewsand Agenda,JournalofEconomicLiterature,Vol.35,Issue2,June,pp.688726. McKinnon,R.I.(1973)MoneyandCapitalinEconomicDevelopment,Brookings Institution,Washington. Metwally,MokhtarM.(1984)TheRoleoftheStockExchangeinanIslamic Economy,JournalofResearchinIslamicEconomics,Vol.2,No.1,pp.1928. Meyer,J.R.andEdwinKuh(1957)InvestmentDecision:AnEmpiricalStudy, HarvardUniversityPress. Meyer,J.R.andR.R.Glauber(1964)InvestmentDecisions,EconomicForecastingand PublicPolicy,Boston,HarvardUniversity,DepartmentofBusinessAdministration, ResearchDivision. Milgate,Murray(2011)UnsustainableEquilibria,CambridgeJournalofEconomics (inpress). Mirakhor,Abbas(2009)RecentCrisis:LessonsforIslamicFinance,SCUMVisiting ScholarProgrammePublicLecture,SuruhanjayaSekuriti,Malaysia,29thSeptember 2009. Mirakhor,Abbas(2010)HopesfortheFutureofIslamicFinance,InstituteofIslamic BankingandInsurance,2010.

31

Mirakhor,Abbas(2011)KeynoteAddress,FoundationsofIslamicFinance ConferenceSeries,EpistemologicalFoundationofFinance:Islamicand Conventional,March810,2011. Mishkin,Sarah(2011)MiddleEast:MarketRemainsBuoyantDespiteUnrest, FinancialTimes,May11,2011. Modigliani,F.andM.Miller(1958)TheCostofCapital,CorporateFinanceandthe TheoryofInvestment,AmericanEconomicReview,Vol.48,pp.261297. Modigliani,F.andM.Miller(1963)CorporateIncomeTaxesandtheCostof Capital:ACorrection,AmericanEconomicReview,Vol.53,pp.433443. Myers,S.C.(1977)DeterminantsofCorporateBorrowing,JournalofFinancial Economics,Vol.5,pp.147175. Myers,S.C.(1984)TheCapitalStructurePuzzle,JournalofFinance,Vol.39. Myers,S.C.andN.S.Majluf(1984)CorporateFinancingandInvestmentDecisions WhenFirmsHaveInformationThatInvestorsDoNotHave,JournalofFinancial Economics,Vol.13. Oakley,David(2011)GoodOmensAmidTurbulence,FinancialTimes,Special Report:IslamicFinance,May11,2011. Pagano,M.(1993)FinancialMarketsandGrowth:AnOverview,European EconomicReview,Vol.37,pp.613622. Sachs,J.D.(1985)ExternalDebtandMacroeconomicPerformanceinLatin AmericaandEastAsia,BrookingsPapersonEconomicActivity,Vol.1985,No.2. Scherer,F.M.(2006)ANewRetrospectiveonMergers,ReviewofIndustrial Organization,Vol.28,Issue4,June2006,327341. Sen,Amartya(1962)ChoiceofTechniques:AnAspectoftheTheoryofPlanned EconomicDevelopment,OxfordBlackwellPublications,1962. Shaw,E.S.(1973)FinancialDeepeninginEconomicDevelopment,TheHebrew UniversityofJerusalem,WorkingPaperNo.233. Sheng,Andrew(2009)FromAsiantoGlobalFinancialCrisis,CambridgeUniversity Press,NewYork,2009.
32

Sheng,Andrew(2010)IsIslamicFinancetheNewChallengetoWallStreet?, Commentary,TheChinaPost,7November2010. Sheng,Andrew(2011).FinanceCannotbeLefttoFreeMarkets:AnAsianTributeto Minsky,20thHymanP.MinskyConference,LevyInstitute,BardCollege,New York,15thApril2011. Shiller,R.J.,(2000)IrrationalExuberance,PrincetonUniversityPress,NewJersey. Schleifer,A.,(2000)InefficientMarkets:AnIntroductiontoBehaviouralFinance,Oxford UniversityPress,Oxford Singh,A.(1992)CorporateTakeovers,inTheNewPalgraveDictionaryofMoneyand Finance,editedbyEatwell,John,Milgate,MurrayandNewman,Peter,Macmillan, LondonandNewYork,pp.480486. Singh,A.andHamid,J.(1992)CorporateFinancialStructuresinDevelopingCountries, IFCTechnicalPaperNo.1,WorldBank,Washington,DC,(xii+147pp.). Singh,A.(1995)CorporateFinancialPatternsinIndustrialisingEconomies:AComparative InternationalStudy,IFCTechnicalPaperNo.2,WorldBank,Washington,DC,(ISBN 0821332317). Singh, A. (1997) Financial liberalisation, the Stock Market and Economic Development, Economic Journal, May, pp. 771782. Subsequently republished in Portuguese in Nova Economia, Vol. 8, No. 1, July 1998; also republished in Controversies in MacroEconomics: Growth Trade and Policy, pp. 206218 ed. by H. Dixon,Blackwells,Oxford.2000. Singh, A., (2003) Corporate Governance, Corporate Finance and Stock Markets in Emerging Countries, Woking Paper No. 258, Working Paper Series, Centre for Business Research, University of Cambridge. A revised version of this paper has beenpublishedintheJournalofCorporateLawStudies,Vol.3,Part1.April,pp.4172. Singh, A., Glen, J., Zammit, A., De Hoyos, R., Singh, Alaka, Weisse, B. (2005), Shareholder Value Maximisation, Stock Market and New Technology: Should the US Corporate Model Be the Universal Standard? AsiaEurope Papers, Discussion Paper No.1,July2005.AlsopublishedasCBRWorkingPaper315.

33

Singh, A. (2007) Economic Crisis and the Asian Way of Doing Business, The BusinessEconomist,Vol.38,No.2,2007,pp:921. Singh A. (2008) Stock Markets in Low and Middle Income Countries, Cambridge University CBR Working Paper No. 377, December. Subsequently published in revisedformasSingh,A.(2010)AretheInstitutionsoftheStockMarketand the Market for Corporate Control Evolutionary Advances for Developing Countries? Fontana, G., McCombie, J. and Sawyer, M. (eds.), Macroeconomics, Finance and Money:EssaysinhonourofPhilipArestis,PalgraveMacmillan,pp311326. Singh, A. (2011) Financial Globalisation and Human Development, forthcoming intheJournalofHumanDevelopmentandCapabilities. Standard&Poors(2011).FundRatings.Standard&PoorsFinancialServicesLLC, TheMcGrawHillCompanies,Inc.,USA Stiglitz,JosephE.(1969)AReExaminationoftheModiglianiMilerTheorem; AlsoinReviewofEconomicsandStatistics,Vol.59,1969. Stiglitz,JosephE.(1988)WhyFinancialStructureMatters,JournalofEconomic Perspectives,Vol.2,No.4,pp.121126. Stiglitz,JosephE.(1994)TheRoleofTheStateinFinancialMarkets,Proceedingsof theAnnualWorldBankConferenceonDevelopmentEconomics,WorldBank, WashingtonDC,1994. Stiglitz,JosephE.(2005)Modigliani,theModiglianiMillerTheoremand Macroeconomics,PaperpresentedattheFrancoModiglianiandKeynesianLegacy Conference,NewSchoolUniversity,April1415,2005. Sundararajan,V.(2011)IslamicFinance,WritingsofV.Sundararajan,Editedby Ahmad,Jaseem.andKohli,SHarinder,SagePublicationsNewDelhi. Tan,EuChye(2009,reviewof)IslamicFinancePrinciplesandPractice,byHans Visser,EdwardElgar,2009.UniversityofMalaya,KualaLumpur. Tichy,G.(2002)WhatdoWeKnowabouttheSuccessandFailureofMergers?, JournalofIndustry,CompetitionandTrade,Vol.1,Issue4. Tobin,J.(1984)OntheEfficiencyoftheFinancialSystem,LloydsBankReview, pp.115,July.
34

Toutounchian,Iraj(2008)TheRoleofCentralBanksinIslamicBanking,Instituteof IslamicBankingandInsurance,September29,2008. VanDuyn,Aline(2011)TheUS:MovesareUnderWaytoLowerBarriers, FinancialTimes,May11,2011. Villamil,AnneP.(1992)TheModiglianiMillerTheorem,TheNewPalgrave DictionaryofMoneyandFinance.

35