Monday, July 11, 2011

On Riba

When I mentioned usury before I talked about Catholic principles. It might be useful to talk about an alternative form of anti-usury theory, as it is found in Islamic jurisprudence.

As with Catholics and usuria, Islam forbids what it calls riba on loans. Indeed, it is considered one of the Seven Heinous Sins, in line with such notables as idolatry, murder, and stealing from orphans, and ranked as far more serious than sins like adultery. This is for Muslims absolutely unequivocal; while neither the Old Testament nor the New Testament has an absolute prohibition (or any permission, it should be said) on usury itself, thus leading Catholic discussions of usury to talk about it in terms of broader principles, the Quran very definitely does. One additional important difference from Catholic accounts of usury is that Islamic accounts of usury have traditionally insisted that it is a sin to pay usurious interest as well as to demand it (Catholic accounts always see the usury-payer as a victim of injustice and not as a committer of it, even if the usury-payer is sometimes a victim of his own stupidity as well as of the injustice of the lender).

But, of course, Islamic banking has a famous history, and banking on explicitly Islamic principles is today a thriving growth industry, and such banks are obviously making profits. So how do banks make money given such strictures? As in the Catholic case, riba does not include all interest, but only interest that is not compensation for provision of service or risk taken.

In addition, Islamic banks build their business model on a broad range of practices taht are collectively called share of profit and loss. Suppose you come to a bank because you want to buy a car. One thing that could happen in an Islamic banking system is a cost-plus or cost addition loan: the bank, after its research, might enter into an agreement with you to buy the car itself and resell it to you at a profit on a favorable installment plan. (In practice, many Islamic jurists tend to regard this method of lending as an emergency method, to be used only in cases where there is clear need by the borrower and other methods will not be suitable to the case; but also as a matter of practice it seems a fairly common way of handling things.) For this to count as a legitimate transaction under Islamic law, there are certain rules that have to be followed: the bank can ask for collateral, but cannot usually charge fees for late payments unless it donates them to charity (among other reasons, to prevent banks from pushing installment plans that encourage lateness in order to collect the fees), and so forth. The most important of these rules is that there has to be an honest statement of what costs the bank actually faced in the transaction, so that it can be seen that the bank's profit is reasonable in light of the costs (as far as I've been able to determine, there's no standardized way to do this). Islamic jurists are divided as to whether it is legitimate to include considerations about the time value of money itself in this assessment.

Another sort of loan is the joint-venture rental loan. In this case, there is an assumption of profit. Suppose it's not just any car, but one that you will hire out for profit. The bank then might form a partnership with you to buy the car. This partnership (you and the bank) then rents the car to you. As partners you and the bank share the rent. Your share of the rent goes toward buying the bank out at the original price of the partnership (since rent is divided according to share in the partnership, this means that your share of rent will get larger over time). If you default, the car is sold by the partnership, which dissolves, dividing the proceeds among the partners. A simpler form of the same kind of thing occurs when the bank essentially just operates as an investor in your business.

There are also loans of a pawnship and rent-to-own types. Islamic banks pay interest on savings accounts just as Western banks do; it is, however, seen as a gratuity. As a gratuity it cannot be guaranteed by any sort of contract; but the incentive to offer it is so high (if the bank stops offering it, or becomes unreliable in offering it, people start pulling their money out of the bank) that it is more or less guaranteed by the market. Islamic banks will also often lend to good customers at zero interest, and they can sometimes make a considerable amount of money on such loans, because tipping the bank is expected. The tip is technically at your discretion, and you aren't legally bound to it, but it is considered shameful to leave the bank worse off rather than better off for having loaned to you. Under such cultural circumstances it is sometimes, if you were willing to accept the greater risk, more profitable to lend at zero interest than it would be to charge interest up front (which would remove the factor of shame and increase the likelihood that you would be able to get no more than the bare minimum of profit possible).

There are many, many more kinds of loans possible under Islamic jurisprudence; every time I think I've come across an exhaustive list, I find that there are types of loans that are not included. None of this is to say, of course, that there is no usury in Islamic banking, since there certainly is, to the extent that banks are lazy, bankers are corrupt, and borrowers can be manipulated, all three of which at least sometimes happen in every banking system, and often depend on things other than banking practices. And some of the practices end up being, of course, controversial. Rather, we see that there is much greater emphasis on finding means of profit that avoid association with what falls under the prohibition against usury.

One of the myths that's important to reject is the myth that crackdowns on usury destroy banking systems. The historical record is actually much less clear. Sometimes it does, and sometimes it is associated with golden ages of banking, as banks in response apply ingenuity to the situation and come up with new kinds of loans that avoid falling under prohibitions -- generally by giving the borrowers more options, or more power, or more flexibility. Some of these newly discovered types of loans end up being extraordinarily profitable new sources of revenue. That is, sometimes such crackdowns harm incentive to loan; sometimes they increase incentive to find new kinds of loans (and sometimes they also increase trust in the lending system, which is good for lending systems). The degree to which it is one or the other depends on, among other things, (1) relative difficulty of surviving with less lending versus trying to create new kinds of lending as determined by various forms of supply and demand; (2) cultural expectations for banking and political support of innovative institutions; (3) the health of lending systems at the beginning; and (4) the effectiveness with which the reforms instill trust in both lenders and borrowers that they will benefit under this system of exchange.

Finance is essentially contract engineering in matters of money: it is a practical field that provides means to ends, and the only truths it really deals with are those that concern the viability of the means to those ends. The most dangerous assumption that can ever be made with regard to a financial system is that it is some fact written into the nature of things rather than something constructed by many hands to serve practical purposes -- something that could very well be otherwise. Whether or not the alternatives are worth pursuing, of course, is entirely a matter of relative feasibility and what you really want to do.

10 comments:

  1. Josiah Neeley5:31 PM

    <span>One of the myths that's important to reject is the myth that crackdowns on usury destroy banking systems. The historical record is actually much less clear. Sometimes it does, and sometimes it is associated with golden ages of banking, as banks in response apply ingenuity to the situation and come up with new kinds of loans that avoid falling under prohibitions.</span>

    <span>If creating a new type of loan would have been beneficial in the absence of the prohibition on usury, then there is no reason to think that the type of loan wouldn't have been created in the absence of the prohibition. On the other hand, if the innovation is only valuable as a means of regulatory arbitrage (i.e. if it's value consists in letting you getting around the prohibition while meeting the letter of the law), then this is not valuable as such. That a prohibition leads to this kind of innovation is an argument against the prohibition, not in favor of it.  </span>

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  2. branemrys6:01 PM

    I don't think this is what we find historically; most innovations in lending up to the mid nineteenth century can be traced to some attempt to lend at a profit without violating usury prohibitions (pawn shops and, for that matter, modern-style banks themselves are examples, an attempt to get past the earlier moneylender business model, which to be sustained required practices that were often regarded as usurious). And it's not, in fact, likely in terms of general principles: there is a cost to innovation here as elsewhere, because innovation is not just thinking up an idea but implementing it, and therefore innovation only arises when something makes it more enticing than sticking with what works. This is particularly true in something that has tended to be as highly regulated and suspiciously regarded as finance: trying to implement an innovation without political and legal support is extremely risky business. It's not the type of lending that needs the support of such prohibitions; those are either profitable or not on their own. But innovating often needs some external support of some kind (it need not be a prohibition); it is not ex nihilo, and it is rarely easier and safer than what's already in place. Banking tends to be done at equilibria points: these are where people find things relatively safe and profitable. Other equilibria points may also be safe and profitable, and, indeed, may be safer and more profitable. But changing to them involves work, expense, risk, and general uncertainty; individuals and corporations do not make such moves easily, and entire markets less so.

    You are also assuming that there are no independent moral reasons for the law; that people attempt to conform to the law is not an argument against such laws, even if many do so only in a letter-of-the-law sort of way. I'm also skeptical of your claim that such innovations are not valuable as such. If by that you mean that their falling into the class of 'innovations done to get around laws' doesn't make them valuable, I agree, but this is a very weak claim, and is consistent with individual examples being extraordinarily beneficial. On the other hand, if by it you mean that any innovation that falls in this class is not really valuable, I don't think it's correct. Setting aside incidental benefits they may have, which will just depend on the case, the innovations may well be innocuous in their own right, even if originally done from bad or hypocritical motives, or else may be improvements over what went before. The actual value of an innovation often depends on features that have nothing to do with how it arose.

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  3. branemrys6:28 PM

    I should add that if your worry is out-of-control legislating of such matters, I agree; anti-usury movements have also led to some very, very devastating mistakes on occasion, and such mistakes enshrined in law are not good. But prohibition is broader than legislation, and, indeed, the latter is not always necessary. Islamic banking practices thrive today because there is an intense demand for them; this demand is due to moral prohibition on usury, not legal prohibition. Likewise, law may play a role but a wholly secondary one. Islamic banking today seems to work best in a dual-banking system, i.e., in a system that doesn't outlaw its opposite but does have a legal system recognizing the validity of the anti-usury practices and providing some standardization and public recognition of certain rights with regard to such contracts.

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  4. branemrys10:29 AM

    How does anyone investing in anything calculate the values involved in shared investment?

    You seem to have the odd idea that fairness in contract is a matter of numbers. It is not; fairness is a matter of negotiation.

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  5. Ocham2:34 AM

    I'm getting this message about 'more than 5,000 characters', even though there are far fewer.

    The main point I was going to make in my original message was that you are confusing 'numbers' with 'accounting'. To account for a charge is to break it down in a way that shows its true causes.  I'm fairly passionate about that, having had a number of bitter run-ins with providers of mortgages, savings plans, banks etc. over many years. 

    You seem to be defending the principle that it is OK to disguise the reasons for a charge in whatever way. I strongly and passionately disagree.   

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  6. Ocham2:38 AM

    >>You seem to have the odd idea that fairness in contract is a matter of numbers. It is not

    It's a matter of accounting - i.e. fairly accounting - for the value of the contract. If the charge is really for interest, it is deeply wrong to call it a 'payment plan charge'.  It also makes it more difficult for the customer to check if it is fair.  If it is explicitly stated as interest, I can check in the Financial Times or somewhere else, and challenge it.  If a 'payment plan', I have no way of checking.

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  7. Ocham2:42 AM

    On your point about supply and demand, well, the market has to be efficient, i.e. there needs to be competition to supply the product.  My fear about the Sharia-compliant thing is that it is a form of marketing.  Most marketing plays upon ideas of lifestyle, worries about class-status etc.  This form of marketing depends upon religious fear.  How powerful is that. A small number of banks who are able to supply the product, an absolutely huge customer base.  They can make whatever profit they like, can't they.

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  8. branemrys11:05 AM

    Again, interest has a broader meaning in usury discussions. Islamic banks that take into consideration things like time value are required to state that they are doing so in a declaration of costs which customers can compare to what they are charged. Islamic banks that don't, won't have any problem with this whatsoever: they are merely getting a profit from buying and reselling on better terms (in this case, under a better payment plan) than the person could have done originally. This is a service, and therefore can receive profit. There is no disguising of interest, at least if the bank is properly fulfilling its obligations under Islamic law: everything has to be accounted for. And you are, I think, underestimating how much easier it is for borrowers to watch their back with a payment plan than it is by keeping track of interest rates: the overwhelming majority of borrowers simply don't have an acquaintance with modern finance that can be assumed adequate for understanding what they are getting into. But people buy and sell and rent all the time, and can make savvy deals in such matters without understanding the slightest about what risk-free rate is.

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  9. branemrys11:07 AM

    I would like to point out that your point in the previous comment, "To account for a charge is to break it down in a way that shows its true causes," is exactly what you attacked me for in my original post: it was the recommendation you denied, arguing that the natural way to deal with usury on the standard approach was to require lenders to give a precise and explicit justification of interest they are charging the borrower. Your very first argument was the argument that they don't have to do so because risk-free rate automatically justifies it.

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  10. branemrys11:22 AM

    No, the market doesn't have to be efficient. We are talking about usury, remember; any injustice arising from supply and demand in resale or rental is likely going to be a different kind of injustice and would have to be dealt with on different principles. Islam, like Catholic Christianity, has those, too. But justice here, as elsewhere, is rooted in the negotiation, not what the market is doing: what can typical customers do and what can they get in return for their money. Markets work statistically; ethics doesn't.

    Perhaps it plays on religious fear, but it offers them more than you ever will. You can talk fair interest rates all you want, you aren't offering many of the more conservative customers of Islamic banking a fair loan, because you aren't offering them anything whatsoever that they could accept, because they're at least going to have doubts as to whether you are charging them usury. You aren't meeting their demands, you aren't fulfilling their needs, and you never will at this rate. You can drum up all the images of manipulated masses you want -- which I note is another bit of marketing -- but you are offering them nothing as an alternative. This huge customer base -- the modern banking system has had decades to do something about their needs, and done nothing but lecture them about what finance really is.

    I am not comfortable with your devotion to the efficient market hypothesis; it has not been economic orthodoxy for a good fifteen years now. Even its major proponents today concede that many markets (e.g., emerging ones) are not, in fact, efficient; and no reputable economist today thinks that efficient markets guarantee good prices; there is just too much evidence that efficient markets allow efficient distorting of prices as well as efficient equilibration of them, and, while this is much more controversial, too much evidence that most markets don't have the features they should have if they were efficient. Slavish devotion to it leaves one unable to say much about much. Perhaps you have some really good argument that no one has answered, or keep putting it forward due to some nuance I'm not getting, but I don't know why you keep insisting on it when it's so out of favor today.

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