Freitag, Februar 29, 2008


One of the most important things any investor should know about any financial instrument is what that instrument does. It is not merely due diligence, but has to do, more fundamentally, with holding those who run the funds accountable: you should know what your money is doing.

What do you call a financial instrument that provides no information regarding investment structures, let alone what the guiding principles are behind investment decisions, besides describing them as "ethical" or "socially acceptable"?

I'd call them a seriously flawed and completely unacceptable financial instrument.

Why? Should be fairly obvious: as an investor, you are paying the salaries of those making the investments for you. They need to be doing that for which they are being paid for. As an investor, you've made a choice of taking your hard-earned money and allocating to a certain portfolio mix to meet and match your expectations regarding returns, be these low volatility and income streams or high volatility and capital gains.

But investing your money in an investment instrument that lacks even the most basic transparency, where you cannot know where the money is being invested? That blind trust, trust that no investor should ever grant except in very unusual circumstances, usually having to do with the necessity of avoiding conflicts of interest when elected to a political office.

I'd call such financial instruments an invitation to fraud, corruption and a great, great way of getting away with lying to your investors. Especially so when there is no standard law or practice for these instruments.

Others, of course, call them Sharia-compliant.

See this.

What are these instruments? They're not allowed to charge or pay interest, may not invest in activities that are "harmful" under sharia law, such as the manufacture of alcohol or gambling, and both risks and profits are shared.

That, apparently is the basis of what entails a sharia investment: you can see more of what they entail here, which gives a basic overview.

This is an interesting quote:

A heavy non-performing portfolio and default on part of clients is a serious problem confronted by the Shariah compliant financial product provider.

In other words, reality is different than ideology. While sharia is supposed to be faith-based and reflect cooperation and mutual interests, reality is such that fraud and deceit on the side of the borrower appears to be about as easy as it may be on the side of the lender.

Looking beyond these mundane problems, there is something more fundamentally flawed with the sharia philosophy: that no one should profit from the indebtedness of others.

The obverse is the core of modern finance, which is based on the idea that money itself has a cost, and that if you want to use money that is not yours, you should pay a price to do so.

Sharia would turn that around and bring back traditional, conservative banking practices that have proven to be corrupt and incompetent (because they are based not on objective analysis, but rather on the personal preferences of the banker). It has all the hallmarks of long-lost days when investment decisions were made on the basis of what the bankers wanted to happen, rather than the best allocation of capital for the best return given acceptable risk limits. Sharia is inefficient and breeds inefficiency, forcing banks to get into areas of activity that it shouldn't be in.

Let me give you an example: you need a car. Normally you could go to the bank, they'd check your credit references, make you the loan, i.e. give the money to you, and you'd then buy a car. A murabaha loan, on the other hand, has you going to the bank, the bank then buying a car for you, and you paying installments on that car until it was paid for (plus a fee that substitutes for interest payments).

This is inefficient, as the bank has no business being in the business of buying cars for you. As a consumer, you will pay for that: as a bank, your flow process will be slowed and you will be carrying personnel in excess of what you really need to conduct your core business. It's not like you can't do it: it's just not efficient.

But there's more to it: it removes risk for borrowers, which is not a good idea. If I take a musharaka loan, the bank becomes co-owner of a property that I buy. Under normal banking, someone getting a mortgage has an enormous incentive to repay it promptly, since failure to do so generally leads to default and loss of the property. In other words, when I buy a house via a mortgage, I'd better pay the mortgage every month, since I will, otherwise, lose my ownership rights to that house. Under musharaka, there is no such construction: the consumer keeps his partial ownership, and it is the bank's problem of recovering their costs: the risks here are highly asymmetrical, since if you have a non-performing exclusive tenant, you as lender will not be able to recover your costs.

Fundamentally, sharia does no cover what the Germans called "Trittbrettfahrer", or those who simply jump on the running boards of an auto and let them be taken wherever the car is going, taking advantage of the fact that the driver doesn't want the hassle of stopping and getting them away from the car: it's all about getting something for nothing.

Sharia investing, beyond the lack of transparency, means emulating the philosophies and principles that have led Muslim nations to be the great economic powerhouses they are today (subtracting oil revenues, of course). Nothing more, nothing less. It has become attractive only because there is simply so much money available for investing in these instruments. That can be the only rationale for sharia investing.

What is the saying? A fool and his money?

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