Jan Aldert Bergstra,
Utrecht, The Netherlands
Cresent-Star Finance is a phrase that we intend to use presently and in forthcoming blogs and papers to indicate a class of abstract financial systems. We write CSF systems for the class of these systems. CSF systems may be considered abstractions and modifications of systems of Islamic Finance. Different designs for CSF-systems play a role in comparative analysis.
The key reason to think in terms of CSF systems rather than in terms of IF (Islamic Finance) systems is that for some CSF system S it can hardly be assessed in a convincing way merely by a team of authors whether or not it classifies as a valid IF system. The class of CSF systems can be studied impartially and perhaps on the long run some systems can be recognized as either abstractions of accepted IF systems or as designs for acceptable IF systems.
CSF systems provide financial products and procedures in such a way the for resulting financial processes the following 6 requirements can be met in a reasonable (or even optimal) optimal way.
1) In case of a loan, the guarantees of cumulative returns to the lender must not exceed the original principal amount.
2) Low probability (downside) risks, both short-term and long-term, must not have excessive consequences for those at risk.
3) The presence of low probability (upside) opportunities (gamble) must not be the main reason for the use of a financial product by the party involved who may benefit from these opportunities when they materialize.
4) Spot sale and credit sale of goods, rights and services are the main sales transaction types. In a sales transaction there must be information completeness (that is, it must be known what is sold). It must exceed a minimum and it must be optimized. Returns on investment must bear a positive relation with investment success.
5) When deciding about a transaction all parties involved are entitled to equal information about the object of the transaction. Information symmetry needs to be optimized.
6) When deciding about a transaction all parties involved must freely make their own decisions.
In these requirements one may recognize various tenets of Islamic Finance. But there are a number of differences worth mentioning:
a) The use of arabic words and phrases is avoided when writing about CSF, for the simple reason that these terms have too many connotations generated by their use though the centuries. As non-Arabic speaking authors we have no chance to use words like riba, maisir, gharrar, jihad and shari'ah in an appropriate way. We don't even have a valid approach to their correct spelling after transcription, let alone to an understanding of the varieties of meaning of these terms.
b) The prohibition of interest is not mentioned as a requirement because it is not sufficiently clear what that means (see our paper on "Reduced Product Set Finance" on http://arxiv.org/abs/1012.4291). Whether or not a financial product involves interest requires an analysis, which may not be easily performed.
c) We need the possibility to criticize a proposed design of a CSF system in the light of the criteria 1)-6) above. But we don't want to be critical about any system of Islamic finance for which many other design requirements may be at stake.
d) Islamic finance has emerged from political Islam, and as such its development is itself an act of jihad. Here jihad is understood as a systematic and uncompromising effort towards a better world (from an Islamic perspective at least) that may inspire others both inside and outside Islam, without any militant or imperialistic connotation. But jihad and truth seem to be two sides of the same coin. The mechanism of jihad may be a disincentive for critical questions and investigations concerning Islamic finance and it may even promote a less than objective dealing with facts. For instance the omnipresent phrase that "Islam strictly forbids all forms of interest" can hardly be taken for granted without further analysis. There are so few assertions held true by all current branches of Islam. It is difficult to accept Islam as a singular noun in such assertions.
e) So we may try: "CSF = (IF -- jihad -- piety) + logic + micro-economics", where "--" represents subtraction. This kind of identity is problematic anyhow, but yet it gives a sense of direction which may be of heuristic use. More meaningful equations of this kind may emerge in due time.
f) The introduction of Islamic finance has been without doubt an achievement of significant creativity and foresight. Who could imagine around 1930 that by simply insisting on the removal of interest payments in the course of 80 years a thriving banking sector would emerge which turns the concept of "Islamization of modernity" into a remarkable reality. However, we don't want to claim that a conceptual investigation of the wide range of design alternatives for mainstream Islamic Finance will contribute to its further successes. For a conceptual and impartial investigation of CSF the worldwide progress of Islamic Finance as known today is of course immaterial, but for the study of Islamic finance per se, that cannot be said.
Having thus set out the objectives of CSF's and their investigation one may ask what can be done in practice. Many different issues can be approached. Here we will discuss the topic of savings accounts which has been looked at in some detail in the paper on RPSF (http://arxiv.org/abs/1012.4291). We now assume that not only the account but also the bank is a financial product. The bank B is a product used by its owner, now called BO. The setting that we have analyzed comprises the following ingredients and assumptions.
1) A intends to put amount f on a savings account controlled by bank B for the duration of 1 year.
2) BO can guarantee, because of state regulations that A will be returned the principal amount f at the date of maturation.
3) B can use the saved money by lending it to another party in a profit/loss sharing arrangement and make a profit from that.
4) B promises to pay interest x = i . f (with i the rate of interest) in order to make A share in the profits generated by means of his money, and for that reason in order to encourage A to save the money with B rather than with its competitor C.
The problem of this setup is that A gets the guarantee that he will receive (1 + i) . f after one year without any risk. This can be changed by looking into the (hypothetical and very abstract and simplified) details of B. Let us assume that B is not allowed to perform fractional reserve banking. B has an initial endowment U, and in addition the savings that have been deposited. Further B has cumulative operational results from which compensations for BP have been subtracted. At the day B needs to return the principal amount plus interest to A this money may not be available, because B may have made losses with investing A's or other customer's money, without any compensation for these losses generated by deposits of new savers. Suppose that K is in cash with B. If K > (1 + i) . f then B receives (1 + i) . f and the loan is closed. This is also possible if K = (1 + i) . f But if K < (1 + i) . f, then the state guarantees have to be used. Now this guarantee will only help B to return the principal amount f, and not the interest. Thus, if K < f or K = f then the bank pays K and the state adds f - K, and if K > f then the state adds nothing and the B returns K.
By taking the bank as a product into account the savings account (understood as a product) now involves a bearable downside risk for A. A does not have the full guarantee that interest will be paid, that only takes place if B's business is adequate at the time of expiration of the savings deposit. Let us consider the six criteria for adequate financial products mentioned above. Compliant to the requirement (1) A's guarantees don't exceed his original principal amount. Compliant with (2) the down-side risk is limited and its consequences are not excessive. Compliant with (3) the reason for A to save is not a matter of gamble (the expectation that the bank B makes a profit is quite well-founded, although sometimes it may not). (4) is more difficult: A has no information about exactly which investment activity B plans to carry out with his money, even if A has significant information about B's past and current activities. (5) is problematic because BO may know that unlike previous years he will make a loss, and BO may be happy to receive A's deposit in order to return principal amounts to other clients without having to ask help from the authorities. In this case BO may know quite well that A should not expect more that being f returned. Alternatively it is possible that A's deposit allows B to make a very good buy which generates very high profits in comparison to which the promised interest payment dwindles. Probably (6) is unproblematic.
Of course we can take into account a more precise formalization of bank behavior. But it is unrealistic to expect that the state which guarantees A the return of its principal amount f is very much interested in what exactly was done with A's money by B. Indeed if A happily survives while it can prove that the investment made with A's money was a failure the A might be asked no refrain from receiving interest payment on that ground, but if the losses are so problematic that capitalization of the investment cannot enable B to return the principal amount it is unreasonable to expect the state to support B if other operations of B are sufficiently profitable to make up for these losses. To sort out which money was used for what purposes one may assume that B works in an entirely sequential fashion and keeps track of incoming amounts and spends for outgoing amounts in that same order. This "rule" determines exactly for what purposes various savings have been used. This is by no means enough to define a yield for each individual payment that was performed by means of A's money, but by means of activity based costing that can in principle be done.
What we find is that the difficulty in designing a CSF savings mechanism lies with conditions (4) and (5) rather than with the concept of interest payment as such. Assuming that putting money on a savings account should be accessible to those who have no incentive to or are incapable of analyzing and comparing different investment options for B it is hardly reasonable to ask B to had over more information to A about the use of its money. By devising a more complex scheme for relating the incoming transfer stream to the outgoing transfer stream (whenever an outgoing transfer is performed compartments of all yet outstanding and not fully used incoming transfers may be made use of to combine into the outgoing amount), one may get closer to a decoupling of A's money from any of the banks specific activities, while still being able to disclose reasonably accurate information on how all savings are used. As it stands information concerning (4) and (5) can be complete, symmetric and uninformative at the same time.