An Islamic Approach to Macro-Prudential Regulation

Video recording of talk at 3rd BANK INDONESIA INTERNATIONAL SEMINAR ON ISLAMIC FINANCE, Presented at Session 4: Macroprudential Policy Framework for Islamic Finance, Nusa Dua – Bali, Indonesia 30th & 31st May 2013. Video is followed by summary of talk

1       A Three-Dimensional Approach

It is well-known that the Global Financial Crisis 2007, which made millions homeless, occurred due to misbehavior of the financial sector. The parallels to the Great Depression are striking; see Completing the Circle: From GD ’29 to GFC ’07. After the Great Depression, a stringent set of laws to regulate the financial sector was enacted in the USA, which prevented banking crises for fifty years. Reagan and Thatcher dismantled this structure and began an era of financial de-regulation. This led to a repeat of the unethical behavior by financiers, and eventually the GFC. After the GFC, the question of how to regulate financial markets has again assumed importance. There are many proposals on the table, and some – like the Dodd-Frank act – have even been written into the law. Our goal in this paper is to consider the issue of regulation of the financial sector from an Islamic perspective. This allows us to step out of the one-dimensional framework created by Eurocentric assumptions which form the basis of the conventional approach to financial regulation; see The Puzzle of Western Social Science for a demonstration that conventional social sciences are founded on concealed Eurocentric assumptions.

An Islamic approach to regulation is three-dimensional: Social, Institutional, and Regulatory. The Eurocentric approach takes the social and institutional structures for granted, and works on the third, and least important dimension. However, the Islamic approach requires consideration of all three dimensions:

1. Social Norms
2. Institutional Structure
3. Regulation and Legal Controls.

We provide a very brief sketch of the history of regulation of financial sector in the West over the past century. This is to show how the one-dimensional approach based purely on the third (and least important, from an Islamic perspective) dimension has been a failure. The final section sketches a three-dimensional Islamic alternative.

2       Social Transformation

The pre-Islamic Arabian society, known as the “Jahilliyya”, or the age of ignorance, was well known for its savagery. The bonds of kinships and clans were held to be superior to all others. The message of Islam, brought by the Mercy to all nations, with compassion and brotherhood of all humanity, and holding justice above all personal matters, was alien to such a society. The revolution of Islam was the transformation of this savage and barbaric society into models of humanity.  The reverse of this transformation occurred in European societies when traditional societies based on Christianity changed to secular modern societies. Some critical elements of this process are details in Polanyi’s “The Great Transformation: The Political and Economic Origins of Our Times” and in Tawney’s “Protestantism and the Rise of Capitalism”.

An essential component of the Islamic approach to regulation is the construction of society based on norms of cooperation, compassion, generosity, brotherhood, and social responsibility. These attitudes are created by education and training along lines of Islamic models, based on the character and conduct of our Prophet Mohammad SAW. One of the disastrous effects of conquest and colonization of Islamic societies by the West was the loss of our traditional institutions and syllabi for training our children. These were replaced by Western educations, which instill alien social norms and ideologies into the Islamic youth.

Western social science is based on a parody of human character, most explicitly articulated in the cold and calculating robot known as homo economicus. The idea that human character and social norms can be changed is not part of WSS, which treats human beings as particles and societies as planetary systems subject to unchangeable laws like those of astrophysics; see Mirowski’s More Heat Than Light for documentation. In fact, social norms can be changed in systematic ways; see for example Cristina Bicchieri “Norms in the Wild: How to Diagnose, Measure, and Change Social Norms”. The idea that socially beneficial outcomes can be achieved when everyone acts greedily putting self-interest ahead of society – encapsulated in the “Invisible Hand” – is patently ridiculous; see Zaman “Failures of the Invisible Hand”. Quite contrary to teachings of economic theory, children are born with social instincts. Developments in evolutionary biology have shown that cooperation can be essential for survival, and be superior to competition; see David Sloan Wilson “Does Altruism Exist?”.

3       A Failed European Experiment

The world today is the outcome of a European experiment which failed. After rejecting religion and afterlife, secular modernity placed faith in observables alone. Rationality meant caring only for our personal happiness, since there were no rewards for good behavior to be expected. This utilitarian philosophy encourages greed, selfishness, hedonism, and power. In the social arena, the ethics of Social Darwinism prevail. The assumption is that Cut-throat competition will lead, via survival of the fittest, to most efficient organizations. Regulation is necessary to ensure “fair” competition – remaining within boundaries. This leads to a paradox which has emerged with great force in the literature on public choice (Buchanan, etc.): Who will manage the managers? Capitalism relies on a DUAL model – Wise and Just Philosopher-Kings of Plato rule over ordinary humans. That is, the government is supposed to be just and equitable, and enforce fair regulations over the public, which behaves with selfishness and greed, and without any morals.  This mode, which encouraged producers to maximized profits, and consumers to maximize pleasure, without any regard for social concerns, worked for a while. This was because the underlying morals of Christianity remained in place, to allow the dual model to work. However, there was a gradual transition as the public sphere also got infected with the underlying ethic of selfishness and greed. As Max Weber noted “ the Spirit of Capitalism is irrational pursuit of wealth for its own sake.” Early theorists recognized that encouragement of greed and selfishness was a bad thing, but felt that it would lead to quick accumulation of wealth. For example,  Keynes wrote that Love of Money: is a disgusting morbidity – BUT it must be encouraged to allow wealth to accumulate. Later theorists lost sight of the idea that this encouragement of greed was a temporary phase, to be eventually replaced by more humane characteristics. Famously, Milton Friedman wrote that “Making profits is the ONLY business of business”. He argued that business had a moral duty NOT to undertake socially beneficial projects if this incurred any loss in profits. This sentiment became widespread as a result of Business school teachings. For example, Ivan Boesky famously proclaims that “Greed is Good”. The results of teaching that the Bottom Line is Profits, and all is fair in the search for profits have been summarized by Zuboff.

Zuboff: “I spent a quarter-century as a professor at the Harvard Business School, including 15 years teaching in the MBA program. I have come to believe that much of what my colleagues and I taught has caused real suffering, suppressed wealth creation, destabilized the world economy, and accelerated the demise of the 20th century capitalism in which the U.S. played the leading role.”

The patently ridiculous idea that one can build a good society from individuals who care only for their selfish interests – known as the “Invisible Hand” – has led to disastrous outcomes for humanity. It is time to recognize the failure and search for alternatives.

4       Post-Depression History of Regulation

The current approach to Macro-Prudential regulation is based on the idea that we should allow greed but regulate it.  This is the “invisible hand” idea which has failed spectacularly. In wake of the Global Financial Crisis, Greg Smith resigned from Goldman-Sachs, citing changes in the business culture which made it acceptable to exploit the ignorance of clients to make profits for the company. The Islamic approach focuses on changing the culture of the finance industry. Instead of teaching our business students to focus purely on profits, we must teach them to be service oriented and socially responsible. To understand the need for this approach, it is useful to briefly recapitulate the history of regulations which followed the Great Depression of 1929.

 The Great Depression of 1929 occurred when the financial industry and the general public invested heavily in the rapidly rising stocks and real estate, borrowing money for this purpose. When the stock market crashed millions lost their life savings. Unemployment went from <3% to >20% for decades. Foreclosures on farm land created a Dust Bowl where nothing grew. The central reason for this catastrophe was that Banks gambled with depositors money. The Post-Depression Regulation of financial industry was designed to  prevent this. In the 1930’s, a slew of regulations were passed which prohibited competition by capping interest rates, restricting regions of operation for banks, and other measures to ensure safe and secure investment policies. Among these, the most important was the Glass-Steagall Act which created a barrier between banking & finance. It divided bank into commercial and investment types, and ensured that commercial banks handling public deposits could not invest in the stock market. These changes prevented the occurrence of crises for about 50 years.

Some of the key lessons which emerged from the Great Depression are the following:

1. Speculative behavior by financial institutions can lead to collapse of entire economy.
   1. Financial Institutions have incentive to gamble. If they win, they capture the gains. If they lose, the depositors bear the losses.
   2. Economic system does not guarantee jobs for all. Therefore, government MUST support the unemployed.

The Keynesian theory which emerged as a consequence of the third lesson created full employment in Western economies for about fifty years. However, the regulations had not addressed the source of the problem: the risk-seeking behavior of the financial classes. As reported most effectively by Naomi Klein in Disaster Capitalism, the financial classes quietly prepared a counter-coup to get rid of the post-Depression regulations which caused great loss of power, and created greater equity in income distribution (see The Keynesian Revolution and the Monetarist Counter-Revolution). In the 1970’s, the banks started using loopholes in the regulations to move towards seeking greater profits at higher risk. A carefully planned coup by the financial lobby led to the Reagan-Thatcher revolution (see Alkire and Foster Winning Ideas: Lessons from Free Market Economics for details). The central idea driving this counter-revolution was the de-regulation of the financial industry.

De-Regulation & Crises: Early in the Reagan presidency,  the Garn – St. Germain Act of 1982 removed restrictions on the Savings and Loan industry. The consequences are detailed in the eye-opener: “Inside Job: The Looting of America’s Savings & Loans” by Pizzo, Fricker & Muolo. Looters systematically stole more than 100 billion USD from S&L’s with collaboration at highest levels. In order to prevent a repeat of the Great Depression, all losses were covered by the Federal Reserve via a huge bailout. The cost of this bailout was more than the entire profits of the banking sector since the Great Depression. In the wake of this banking crisis, the real cause of the crisis – the de-regulation – was covered up. If you read the Wikipedia entry on the Savings and Loan Crisis, you will see that there are ten or more causes given for the crises, and no clarity as to the real reason for the crisis. This cover-up of central causes is an essential part of financial capitalism. If the real source was apparent, the regulatory solutions could be found. But the financial lobby exerts sufficient power to control the discourse and throw up enough false and misleading theories to create doubt about the real causes of the crises. This doubt, combined with the lobbying power to control political actions, prevents necessary regulations. In this case, the crisis should have blocked the financial de-regulation agenda of the Reagan-Thatcher era, when the very first de-regulatory step led to a huge crisis. However, it did not, because the reason for the S&L crisis was not attributed to de-regulation. Thus the de-regulation proceeded, with even more disastrous effects.

The Subprime Mortgage Crisis which led to the Global Financial Crisis was more or less a repeat of 1980’s Savings and Loan Crisis at a much larger scale. The first step was a repeal of the Glass-Steagall Act via the Gramm-Leach-Bliley Act of 1999. The details of how the Global Financial Crisis occurred have been covered brilliantly by Atif Mian and Amir Sufi in their book “House of Debt”. Two key elements of relevance to our current topic are “fraud” and “risk”. Financial institutions engaged knowingly in high-risk transactions, since they could out quickly with high profits in a game of musical chairs. Fraud occurred because high risk mortgage-based-securities were presented as highly secure investments with cooperation and collaboration across the board in the finance industry. Everyone in the finance industry stood to profit from the sales of these deceptive financial instruments.

5       Lessons From the Global Financial Crisis

The most important lesson emerging from the GFC is the enormously increased strength of the financial sector. Whereas effective regulation had been created in the wake of the Great Depression, this did not occur following the GFC. This is was due to the political power of High Finance. A few hesitant regulatory measures which were passed, were later quietly repealed. In particular, it is instructive to examine the Dodd-Frank Act of 848 pages, which was proposed as a replacement for the Glass Steagall Act, which is only 37 pages. Although Dodd-Frank is meant to prevent speculation by banks, it contains loopholes so big one could drive a truck through them. The concept of “Regulatory Capture” emerged in the Reagan-Thatcher era, when the regulatory authorities were captured by the institutions they were meant to regulate. However, the response to the GFC demonstrate that the finance lobby has capture the entire political apparatus; even the regulatory laws which are passed favor the finance industry. One of the key demonstrations of this was the bailout which occurred following the GFC. The source of the problem was that mortgagors were unable to pay their installments. The simple solution would have been to put a moratarium on such payments, to markdown debt to the reduced value of houses, and to forgive certain types of debt. Atif Mian and Amir Sufi have shown that this solution would be far less costly than the trillion dollar bailouts given to the financial sector, and would also have prevented the Great Recession which followed.

However, this simple solution would not have been in the interests of the top 0.01%; in particular, this solution involved allowing large corrupt financial institutions to collapse. The political power and the control of the narrative allowed the financial lobby to block this solution and replace it by bailout of the financial institutions. Allowing the Great Recession to occur was also favorable to the wealthy coroporations as it created a compliant labor force, and increased corporate profits.  For this we can derive the lesson that the fundamental change required is to reform social norms. Instead of seeking to make profits, we should train our business leaders to seek to serve the public interest. Regulations cannot function when social norms are wrong, because the rich and powerful can always find creative solutions to go around any written set of regulations. This is why the Islamic solutions to regulation problems are three dimensional.

6       Islamic Regulation: Three-Dimensional

The teachings of Islam transformed ignorant and barbaric Arabs of the pre-Islamic era of ignorance into world leaders, and launched a civilization that enlightened the world for a thousand years (see Syed Abul Hassan Ali Nadwi: What the World Lost Due to the Decline of the Islamic Civilization). The first goal of Islamic teachings is to create an internal revolution within the human soul. The Quran tells us about the spiritual journey from the Commanding Soul (Nafs-e-Ammara) to the Contented Soul (Nafs-e-Mutma’innah). The homo economicus of economic theory closely matches the lowest level of spiritual development of the Nafs-e-Ammara, where the human being is completely controlled by his desires. Western theory of regulation assumes a DUAL structure – regulators should be honest, just, ethical, (thereby having high levels of spiritual development) while traders can be greedy, profit seeking, individualists, without social concerns. This dual structure fails, because profit seeking norms eventually corrupt the entire society, including the regulators and the government.

Development of morality and good social norms are central to an Islamic approach. See “Islam’s Gift: An Economy of Spiritual Development” for a detailed explanation of how Islamic Institutional structures are designed to create spiritual progress. An Islamic society is founded on social norms of generosity, cooperation, brotherhood and social responsibility. The institutions of a society are the embodiment of collective goals of a society. The Awqaf (Charitable Trusts) of Islamic society represent the collective intention of spending on others, which is central to the Islamic spirit. In contrast, Western banks embody the spirit of accumulation of wealth for private gain, without any social concerns or moral restrictions. The inherent paradox and contradiction of the capitalist system arises when the financial institutions, instead of serving society, seek to make profits for themselves at the expense of society. It can established empirically that the financial institutions have defrauded the public of enormous amounts of money in over 300 financial and monetary crises over the past few decades. This is responsible for the enormous concentration of wealth that has occurred by transfer of income and resources from the bottom 90% to the rich and powerful. This problem cannot be resolved by regulations, since the rich and powerful find ways to get around the regulations and to corrupt or coopt the regulators. For a discussion of how an Islamic approach to finance would have prevented the Global Financial Crisis, see “Radio Islam Interview: Islamic Economics“

The first step of character transformation leads to an institutional structure which is in conformity with social norms of cooperation and brotherhood. Specific details of such an institutional structure is given in “Building Genuine Islamic Financial Institutions”.  There are many structural innovations embodied in the differentiated financial institutions of Islamic Societies. In particular, Islamic values are represented in the proposal for narrow banking, which would keep the function of safekeeping and transfer of deposited money completely separate from the use of money for business. The first institution would be a “Darul Amanah” for depositors, while the second would be an investment bank allowing people to earn return on money ONLY on the condition of participating in risks of business. A third type of institution not present in the West would be a specialized service oriented savings bank. One example is Tabang Hajji, which provides service for the purpose of travel for Hajj. On a similar pattern Housing Banks could provide residentials services including purchase of housing, and Transport Banks could provide transport services, including purchase of cars.