UAE Laws and Islamic Finance

Laws of the UAE and Islamic Finance

Classification of Islamic Modes of Contract

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Thoughts from Iraj Toutounchian’s Islamic Money & Banking, Integrating Money in Capital Theory

Islamic contracts can be classified into two broad categories: (1) those with variable returns (such as Musharakah and Mudarabah contracts) and (2) those with fixed returns (Installment Sales, Hire Purchase, Jo’aalah, and the like).  The second category may be defined as auxiliary contracts, which can be used in conjunction with the first category or after such has been utilized.  While the first category involves risk, the second type is riskless, which might be more appealing to Islamic banks.  However, there is an urgent need for a government institution to shoulder the burden of risk produced by the public sector and beyond the control of the private sector.  Reducing or eliminating risk for investors requires that the banks pay compensation from their own share of profit by changing the value of Alpha (The ratio of a bank’s share of profit to its capital share relative to that of the potential investor).  This process has to be closely monitored by the central bank and provides uniformity across all banks under its control, wherever they may be located.

Whichever contract an Islamic bank uses, the accountants responsible for submitting balance sheets and P&L statements to the tax authorities do not accept anything under the heading of cost.  Neither accountants nor economists can deny that the Islamic banks’ share of profit paid by investors is a sort of dividend, which is essentially determined after all costs have been subtracted from revenue.

To fulfill all of these functions effectively, an Islamic central bank must have personnel highly qualified in portfolio and risk management and project appraisal.  This is also a must for each individual Islamic bank.

After they have followed the central bank’s instructions to the letter, the banks can safely be allowed to gradually reduce RRR (Required Reserve Ratio) to zero, which will make capital abundant (in perfect line with Keynes’ assertion that there is no reason for capital to be scarce).

Admittedly, the monitoring costs involved in Islamic banking are higher than those of conventional banking but these are outweighed by the potential benefits to be had from reducing unemployment and keeping prices constant.  More importantly, the distribution of income and wealth will be more equitable and guarantees sustained economic development.  The role of an Islamic central bank in this regard cannot be overstated.

The Islamic banking system and Keynesian theory coincide in their aim of ‘getting rid of many of the objectionable features of capitalism.  Keynes acknowledged that ‘it is our best advantage to reduce the rate of interest to that point relative to the schedule of the marginal efficiency of the capital at which there is full employment.’ (Keynes 1936: 375)

In working toward this goal, the Islamic central bank need not act as an independent institution (as it is in the conventional system).  In order to make money an endogenous variable through its integration in the real sector, it makes sense that the institution responsible for financial policy is also part of the institution responsible for fiscal policy.  In other words, we suggest that the governor of the Islamic central bank be a vice-minister under the control and supervision of either the Ministry of Economics or Ministry of Finance.  This will have the effect of making financial policy complementary to fiscal policy.  It has been shown that this financial – fiscal mix will prevent the emergence of the ‘crowding-out effect,’ which concerns many economists. — (Iraj Toutounchian)

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