Tuesday, May 6, 2008

The Question of 'Non-Usurious Interest' - An Inconvenient False

Quote of the Week:
'There's too much political freedom, too many legal rights, too much media. By contrast, I was in Shanghai recently and one day passed a bunch of huts beside the road. The next day they were all gone. The third day there were a bunch of guys rolling out sod and planting trees. And on the fourth day they inaugurated a park.' - Rajiv Singh - (Vice Chairman of DLF [India's largest Real Estate developer]).

Presumably, political freedom, legal rights and media are mere shackles to be cast off. A park, on the other hand, is Progress.
(The source is his interview with the McKinsey Quarterly -) http://www.mckinseyquarterly.com/Economic_Studies/Productivity_Performance/Putting_a_roof_over_India_An_interview_with_the_countrys_biggest_developer_2066

Commentary for the Week:

The Question of 'Non-Usurious Interest' - An Inconvenient False:

This past week I received an excellent email from one of our dear subscribers. Her previous thoughts on Islamic Finance had led her to a point where the definition of usury and the definition of interest were complementary but not the same. Thus, it is possible in this scenario to have 'usurious' interest and 'non-usurious' interest. Non-usurious interest, in this view, is a tolerable 'cost of capital'. Without picking on my dear friend (who is indeed a genius and gets to the heart of the matter very quickly), and indeed others involved in banking / finance / regulation (whether 'Islamic' or not) - I would like to put forth a different view. As always, please remember that Truth is a very precious commodity, something that the Divine has spread among many. Similar to my dear friend, I have been blessed perhaps, with only a portion - my views are solely mine, and certainly do not carry the definitive authority of being 'Islamic'.

At the moment, traditional Islam is perhaps the only large religion where any excess charge / repayment on loans is thought to be expressly forbidden. Christianity, taking its cue from its Catholic subset perhaps, has come to define usury as 'excessive' interest. This latter view is either a very deep understanding of usury that is beyond me, or an inescapable compromise made at a time of great hardship for the Church. Traditional, pre-reformation understanding among the Abrahamic Faiths at least (I do not have any familiarity with others) was that usury is any excess charge or repayment over a loan.

But that is neither here nor there - I can quote texts and texts can be quoted against me. Let us use a simple, but illustrative example instead.

Let us suppose that my wife is rich, and I am quite the opposite (not a bad approximation of reality, but I digress). She has $100 lying around and I need $100 to fix my car. If she were to loan me $100 and stipulate that I must pay her $150 in one year, our moral sense would be revolted. That translates to a robust and definitely usurious interest rate of 50%, and a usurious gain of $50 in absolute terms. If I was to indeed agree to her terms, my wealth would be transferred to her quite quickly.

Let us say then, that in Scenario B, I refuse her terms. I go to a bank/lender who has advertised a very reasonable sounding %5 on loans instead. Let us assume that this is the bank where my wife deposited the $100 in the morning. Since her deposit, they have had an excess capital of $100, against which they can lend more money. As per prevailing regulations and business practices of the conventional system, they are now in a position to loan out 10X the deposited amount, or $1000 (a reserve ratio of 10% for the technically-minded). All day, people such as me go to the bank and borrow what they need, until the $1000 has been completely loaned out. For me, this means that I will have to repay $105 in a year, which is definitely more manageable than $150. I thank my loan officer profusely and walk (remember my car is still being fixed) away happy, feeling that 5% interest is really not that bad compared to my wife's loan-sharking.

Evaluating these two scenarios from my personal perspective, I am clearly better off monetarily in scenario B. But if I leave it at that, not only will I have marriage problems, I have also perhaps missed an important part of what actually just took place. As a concerned husband and citizen, perhaps I should ask - what of my wife, the bank, and the rest of society? If my Mrs. had been the lender, I would have paid an excess of $50 and she would have made $50 (50% x $100). In the second scenario, I would have paid only $5, but how much did the bank make off the same $100 that my wife could have loaned me directly?

I think that if you do the calculation, you will find that 'Lo and Behold!' (my only textual reference for the day), the bank also made a grand total of $50 (the total amount loaned x interest rate or $1000 x 5%=$50). Let me ask you, from a societal perspective what is the difference between my wife making $50 from a principal of $100, and a lender making the same absolute gain from the same $100? Why did we label her business practices 'usurious', but feel warm and fuzzy about the bank? If our moral sense screamed out under the first scenario, why is it so quiet in the second? In both cases, $50 has been taken from society on a principal of $100. Which $50 gain is usurious?

Of course, many will quibble with my simple example. Let me address that right up front. In Canada these days, and under the Basel II Banking Accords (which we helped develop and to which we are a sovereign signatory) - reserve requirements for lenders are actually lower than 10%. This means that lenders can actually lend out more than 10X their deposits. Also, the rates for unsecured loans are substantially higher than the 5% used in this example. In short, the only thing I have grossly overestimated is the capriciousness of my wife, who is in fact quite nice and uninterested in any interest whatsoever.

By seemingly 'saving' myself $45 by dealing with an institutional lender, I have altered the payout for myself, but have not affected the impact on society. In both scenarios, the result at a societal level has been sub-optimal. Perhaps, just perhaps, this example is a reflection of why trying to define non-usurious interest is futile - and God really does know best.

In this case, while that $45 I 'saved' will indeed come in handy for me personally, the fact that the original pain has been spread around amongst many is thin and shallow satisfaction. The sad fact of the matter is that usurious gain is still being made somewhere on God's Green Earth. Even if you and I are no longer paying it in person, our engagement with society means that we do end up paying for it personally.

Of course, in the meantime, all the other fellows who borrowed to have their cars fixed have driven up the price of mechanics and now the $100 is not enough. If only I could be a banker ... (again), but that can be a story for another day ...

Thank you to all who wrote back with their views. A special thank you to my good friend, who wrote in with her views in an articulate and tasteful manner. I apologize for making her views public but not only is pooling our knowledge and questions the way to success, it is perhaps an important measure of success itself. Of course, these views are mine alone and not designed to cause offense, just elicit dialogue on things we usually don't talk about. If you feel you have derived some value from this newsletter, please be kind and forward it to two or three people you would like to have introduced to Islamic Finance so they can subscribe (there is a link to forward the email below). I will NOT be sending advertising or purchase offers to this newsletter list unless my wife calls in the loan.

Finance News:

1. A must see video ... British humour takes on the recent banking crisis ... http://www.youtube.com/watch?v=axAjb6fDsPY&feature=related

2. Back to Portus ... remember how there were two accused co-founders? ... well, this is the prisoners' dilemma in action. For as long as one of them was out of Canada, the other did not confess. Now that both founders are in Canada, one realizes that the individually smart thing to do is to make like a canary and sing ... will this be a duet? ... over 25,000 investors lost money through fraud and Canary No. 1 gets two years ... http://www.reportonbusiness.com/servlet/story/RTGAM.20071119.wportus1119/BNStory/Business/home

3. Absolutely and completely a bad idea ... the last thing we need is somnolent Central Bankers being put in high-pressure situations with public money ... oh wait - we already have that .... but they definitely do not need more powers. Think about it - every crisis that you think they have averted or will avert will be paid for through either inflation or tax increases ... let the market do what it does best and sort itself out ... why should everyone pay for the folly of a few? ... http://www.reportonbusiness.com/servlet/story/RTGAM.20071120.wduguay_staff1120/BNStory/robNews/home

4. Devastating news for the lending and securitization businesses in the US ... if the institution that forwarded the initial loan and the institution trying to foreclose on that loan are different, no foreclosure is possible ... undermines the very foundation of securitization practice, which is that loans can be sold off to other institutions with no adverse effects on legal rights ... http://www.canada.com/nationalpost/financialpost/story.html?id=5ccd6db0-ed6d-45e6-af07-bb41a916d1d9

Economic News:

1. An excellent dissection and blow-by-blow account of the recent Asset-Backed Commercial Paper (ABCP) crisis in Canada ... perhaps some of you will write to the editor of the Report on Business and let him know that we appreciate good journalism ... the must read article for the week ... http://www.reportonbusiness.com/servlet/story/RTGAM.20071116.r-cover17/BNStory/Business/home/?pageRequested=all

2. An excellent 2 page summary of where we stand in our understanding of credit markets, derivatives and money supply ... http://www.blackswantrading.com/files/b7cd13bc5373d1e/bsccc112107.pdf

3. Perilously close to parity ... after my comment last week - stay up loonie, stay up ... don't want to be eating humble pie already! ... Please note that currency markets are notoriously fickle ... they will right themselves and agree with my sentiments in good time ... http://www.reportonbusiness.com/servlet/story/RTGAM.20071119.wloonie1119/BNStory/robNews/home

Islamic Finance:

1. Dare I say that this is a well-run enterprise? One of the few Middle Eastern companies to invest in knowledge-bases abroad ... http://www.zawya.com/story.cfm/sidZAWYA20071108111034

Management Training:

1. Harvard write-up on Moral Leadership ... http://hbswk.hbs.edu/item/5801.html

2. News to use ... How succession issues are likely to dominate operational and financial planning for small businesses in Canada over the next few years ... Not something that people should attempt without good advice though ... http://www.reportonbusiness.com/servlet/story/RTGAM.20071113.wxsmallsuccession13/BNStory/specialSmallBusiness/home

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