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.