THE CASE AGAINST INTEREST: IS IT COMPELLING? by M. Umer Chapra Research Adviser IRTI/IDB Jeddah (Saudi Arabia) Notes for a lecture to be delivered at the International Conference on Islamic Banking to be held in Brunei on 5-7 January 2004

Why a new system of financial intermediation? Is there anything wrong with the prevailing interest-based system ? Why a new system of financial intermediation? Is there anything wrong with the prevailing interest-based system ? Evaluation of a system on the basis of its contribution to : Evaluation of a system on the basis of its contribution to : Efficiency Efficiency Ease and promptness in the transfer of funds from the surplus to the deficit sectors Ease and promptness in the transfer of funds from the surplus to the deficit sectors Economy in transactions costs Economy in transactions costs Stability Stability Equity Equity (Socio-economic justice) (Socio-economic justice)

Interest-based system was never considered to be superior on the criterion of equity. Its superiority claimed on the criterion of efficiency, why? Interest-based system was never considered to be superior on the criterion of equity. Its superiority claimed on the criterion of efficiency, why? Confidence in the Efficiency of the system has been shaken by its persistent instability over the last four decades. Confidence in the Efficiency of the system has been shaken by its persistent instability over the last four decades.

Call for a “New Architecture” Call for a “New Architecture” Sound Macro-economic policies Sound Macro-economic policies Sustainable exchange rates Sustainable exchange rates Proper regulation and supervision Proper regulation and supervision Adequate capital, proper risk management, effective corporate governance, greater transparency Adequate capital, proper risk management, effective corporate governance, greater transparency Why is market discipline unable to ensure the faithful observance of these principles? Why is market discipline unable to ensure the faithful observance of these principles?

Reasons for the ineffectiveness of market discipline in the interest-based banking system: Reasons for the ineffectiveness of market discipline in the interest-based banking system: As a result of the absence of risk-sharing: As a result of the absence of risk-sharing:  Deposits are guaranteed - therefore depositors become complacent and do not monitor the banks carefully - do not demand transparency  Banks rely on the crutches of collateral, which ensures the repayment of their loans - they do not evaluate the risks carefully - tend to extend credit excessively. This promotes:  Public sector deficits  Private sector living beyond means  Highly leveraged short-term debt  Rapid movement of funds  Volatility The greater the reliance on debt and the higher the leverage, the more severe the crises The greater the reliance on debt and the higher the leverage, the more severe the crises

Some Examples: Some Examples: East Asia Crisis East Asia Crisis Long-term Capital Management (LTCM) Long-term Capital Management (LTCM) Foreign Exchange Markets Foreign Exchange Markets Remedy lies in injecting greater discipline in the financial system – How? Remedy lies in injecting greater discipline in the financial system – How? Introduce risk sharing to make market discipline more effective Introduce risk sharing to make market discipline more effective More effective discipline will complement the role of regulators and supervisors and help make the financial system healthier and more stable More effective discipline will complement the role of regulators and supervisors and help make the financial system healthier and more stable

Interest-free finance is intended to inject the needed discipline into the financial system through risk-sharing: Interest-free finance is intended to inject the needed discipline into the financial system through risk-sharing: Risk-sharing by banks ? Risk-sharing by banks ?  The bank shares in the risk with the entrepreneur the entrepreneur Risk-sharing by depositors ? Risk-sharing by depositors ?  Demand deposits (These do not share in the risks and do not (These do not share in the risks and do not therefore get any return –must be guaranteed) therefore get any return –must be guaranteed)  Investment deposits (These must share in the risks – just like shareholders)

What about credit ? What about credit ? There is credit and the rate of return is fixed in advance – Is this interest ? There is credit and the rate of return is fixed in advance – Is this interest ? There is no borrowing and lending – Rather there is purchase and sale of goods and services. There is no borrowing and lending – Rather there is purchase and sale of goods and services. The financier bears some risk in the sales-based modes of financing : murabahah, ijarah, salam and istisna‘ The financier bears some risk in the sales-based modes of financing : murabahah, ijarah, salam and istisna‘ Wouldn’t this bring instability: NO Wouldn’t this bring instability: NO Credit expands in step with the growth of the real sector Credit expands in step with the growth of the real sector Speculation minimized as a result of risk-sharing Speculation minimized as a result of risk-sharing

This shows that even though Islamic finance is more difficult it can be more efficient. This shows that even though Islamic finance is more difficult it can be more efficient.

What about equity? What about equity? Living beyond means Living beyond means Need fulfillment Need fulfillment Full employment Full employment Equitable distribution? Equitable distribution?