Islamic Finance: Tarek El Diwany on the ‘Problem’ with Interest

By
Bank Melli Iran is one of the largest Islamic banks in the world (Image by Pournick).

What is their problem with interest? This is the question that comes to many people’s minds when they see news reports on Islamic Finance and the notion that interest on monetary loans is prohibited – the Islamic prohibition of riba. Few reports try to explore the ‘problem’ but Tarek El Diwany, a speaker at the upcomingCFA Institute Middle East Investment Conference and Islamic Finance specialist, has done just that in a way that financial analysts can relate to.

Tarek, who grew up in England and was a derivatives dealer in the City of London, is now an Islamic Finance practitioner and writer. Tarek has become well-known for his critique of the nuts and bolts of capitalism, particularly compound interest and the proliferation of debt through fractional reserve banking, as explored in his book The Problem With Interest and his documentary, “Why Are We All in Debt?“.

While Tarek’s ideas are wide ranging, CFA Institute produced a video-interview with him (below) focusing on one specific issue: Is there a conflict between discounting and ecological sustainability? In other words, what is so problematical about requiring a compound return while living on a planet with such a fragile ecology?

Tarek contends that discounting underweights the long term. For example, a cash flow of £100 discounted for 30 years at 10% gives a present value of less than £6. On the other hand, sustainability issues, be it climate change or deforestation, are inherently long term, if not inter-generational. When these long-term sustainability issues are evaluated in the standard discounted cash flow (DCF) model, investing in an ecologically sustainable manner involves a cost and will likely emerge as a poor choice on purely financial grounds.

One example Tarek uses is of a farmer who has to decide between two farming methods, financed solely by debt, using the net present value (NPV) as decision criterion. The first is a high intensive farming technique that produces a net cash flow of £150 per annum but causes land desertification after 15 years. The second is a sustainable alternative which produces a perpetual income of £100 per annum by managing land to regenerate indefinitely.

When interest rates rise from 5% to 10%, the farmer decides to use the highly intensive farming technique because it has higher NPV even though it leads to land desertification. So the decision based on NPV analysis runs against ecological sustainability.

The underlying reason, according to Tarek, is that compounding (or its mirror image discounting) is unlike the reality of the world that we live in. In the physical world, things do not go on compounding. In fact, the opposite is true. In the words of Tarek, “fruit rots, buildings become dilapidated.” The point being that common valuation techniques of finance defy the laws of nature.

Tarek argues that the conflict between discounting and sustainability is worsened when  interest-based monetary loans, instead of equity-like profit sharing arrangements, are used for financing. That is because interest on loans must be paid regardless of the outcome of the venture, whereas with an equity arrangement profits may only be shared when there is profit. Equity, says Tarek, provides “very important breathing space.”

Tarek also believes that there are important things in life which cannot be reflected in the form of cash flows. For example, it is usually difficult, if not impossible, to put a price tag on things like pollution and stress. However, it is obvious that human beings place great value on these. This idea is not new but is a powerful one. Perhaps Einstein had something similar in mind when he said, “Not everything that can be counted counts, and not everything that counts can be counted.”

What this suggests is that even in equity financing, moral checks and balances on profit-motive are needed. Thus companies, even if using equity financing, have to balance their profit-motive against such considerations.

Ironically, many of the problems Tarek found with interest-based lending were what he also found in the modern day practice of Islamic Finance. That is because of the gap he, and many other observers, find between the theory and practice of Islamic Finance. Following the CFA Institute Middle East Investment Conference, we will produce another blog on Tarek’s views on Islamic Finance. For now, you can watch this short video interview with Tarek where he explains his views on discounting and ecological sustainability.

This entry was posted in Archives, Economics, News and tagged , , , . Bookmark the permalink.

One Response to Islamic Finance: Tarek El Diwany on the ‘Problem’ with Interest

  1. Robert Hannah says:

    The issue of the social rate of discount has preoccupied secular economists as well. Its a voluminous literature on which I don’t claim expertise, but I came across the following reference, which indicates that the issue has been around for a long time.:
    On the Social Rate of Discount
    William J. Baumol
    The American Economic Review
    Vol. 58, No. 4 (Sep., 1968), pp. 788-802
    However linking the issue to Islamic finance seems problematic to me:
    1. An Islamic mortgage based on the declining ownership model, for example, will have similar cash flow payment requirements to the conventional instrument, and so will not solve Mr. Diwany’s problem. The issue is really about the appropriate capital structure for an agricultural firm (also an issue on which I’m not an expert). I see there is also a voluminous literature, including analysis of sustainability issues.
    2. In the example, an equity investor will have a higher return expectation than a lender, to compensate for the equity risk premium. This places pressure of a different sort on the farmer to maximize return.
    3. In the example, an equity funded short sighted farmer may still farm in a non sustainable manner. It is better to attack the sustainability issue directly with land use requirements, pesticide bans, and sustainable practices certification. Our neighborhood environmentalist will have lots of ideas, but likely needs lots of support.
    Lastly, I would submit that rather than building a parallel financial system, Muslims could make a more useful contribution by joining the debate on social and ethical issues such as agricultural sustainability and the appropriate rate of social discount. Mr. El Diwany’s book is a good step in that direction.

Leave a Reply

Your email address will not be published. Required fields are marked *