Islamic finance in the light of modern economic theory /Suren Basov, M. Ishaq Bhatti

This book provides researchers and students with an understanding of the basic legal tenets of the Islamic finance industry, studying the real economic effects of those tenets using the tools of the modern economic theory. Split into four parts, the book begins with an introduction to the history and a legal framework for Islamic banking, covering typical Islamic financial products such as Sukuk and Takaful and examining the structure of Islamic financial institutions. It then analyzes and discusses the Miller-Modigliani Theorem, which is of direct relevance to Islamic banks which are prohibited to charge interest and often have to rely of profit-loss sharing agreements. Part III of the book introduces the reader to modern mechanism design theory, paying particular attention to optimal contracting under hidden action and hidden information, and final part of the book applies the tools of economic theory to understand performance of Islamic financial institutions such as Islamic banks and Takaful operators. __Islamic Finance in Light of Modern Economic Theory__ brings together all the necessary technical tools for analyzing the economic effects of Islamic frameworks and can be used as an advanced textbook for graduate students who wish to specialize in the area, as a reference for researchers and as a tool to help economists improve the design of Islamic financial institutions. Preface 5 Contents 7 List of Figures 12 Part I Islamic Finance: Rationale, History, Instruments and the Legal Framework 13 Reference 14 1 Introduction 15 1.1 Overview 15 1.2 The Two Worlds of Finance 16 1.3 The Rationale of Islamic Finance 18 1.3.1 The Development of Islamic Banking Worldwide 19 1.3.2 IBF in the Middle East 22 1.3.3 IBF in South Asia 30 1.3.4 IBF in the Southeast Asia 32 1.3.5 IBF in Africa: Sudan 35 1.3.6 IBF in European and Western Countries 35 1.3.7 IBF in Australia 38 1.4 Conclusions 39 References 39 2 Islamic Financial Instruments 42 2.1 Overview 42 2.2 Equity-Based Instruments 43 2.2.1 Mushārakah 44 2.2.1.1 Profit and Loss Sharing 44 2.2.1.2 The Nature of Capital 45 2.2.1.3 Management 45 2.2.1.4 Termination 45 2.2.2 Mudārabah 46 2.2.2.1 Profit and Loss Sharing 46 2.2.2.2 The Nature of Capital 47 2.2.2.3 Management 47 2.2.2.4 Termination 48 2.3 Debt-Based Instruments 48 2.3.1 Murābahah 48 2.3.1.1 The Nature of Cash Flows 49 2.3.1.2 The Nature of Underlying Asset 49 2.3.1.3 Management 50 2.3.1.4 Termination 51 2.3.2 Salam 51 2.3.2.1 The Nature of Cash Flows 52 2.3.2.2 The Nature of the Underlying Asset 52 2.3.2.3 Management 53 2.3.2.4 Termination 53 2.3.3 Istisnā' 53 2.3.3.1 The Nature of Cash Flows 54 2.3.3.2 The Nature of the Underlying Asset 54 2.3.3.3 Management 54 2.3.3.4 Termination 54 2.3.4 Ijarah 55 2.3.4.1 The Nature of Cash Flows 55 2.3.4.2 The Nature of the Underlying Asset 56 2.3.4.3 Management 56 2.3.4.4 Termination 57 2.4 Takaful 57 References 58 3 The Historical Roots and Evolution of Islamic Financial Thought 59 Part II The Law of Unexpected Consequences 62 References 63 4 The Incidence of Taxation 64 4.1 Exercises 67 4.2 Bibliographic Notes 68 Reference 68 5 The Basics of Corporate Finance: The Miller–Modigliani Theorem 69 5.1 The Miller–Modigliani Theorem 70 5.2 Hidden Information and the Breakdown of the Miller–Modigliani Theorem 72 5.3 Prohibition of Riba in the Light of the Miller–Modigliani Theorem 75 5.4 Exercises 76 5.5 Bibliographic Notes 77 5.6 Unexpected Consequences of the Provisions of Islamic Law 77 References 79 Part III Game Theory and Mechanism Design 80 References 81 6 Game Theory 82 6.1 The Normal Form and the Extensive Form 82 6.2 Mixed Strategies and Behavioral Strategies 84 6.3 Simultaneous-Move Games of Complete Information 84 6.3.1 Dominant and Dominated Strategies 84 6.3.1.1 Iterated Deletion of Strictly Dominated Strategies, Rationalizable Strategies and Common Knowledge of Rationality 86 6.4 The Nash Equilibrium 87 6.5 Simultaneous-Move Games of Incomplete Information 87 6.5.1 Harsanyi's Doctrine 88 7 The Revelation Principle 90 7.1 Bibliographic Notes 91 Reference 91 8 Monopolistic Screening 92 8.1 The Monopolistic Screening Model with Two Types 93 8.2 The Unidimensional Screening Model 95 8.3 The Spence–Mirrlees Condition and Implementability 96 8.4 The Concept of the Information Rent 100 8.5 Three Approaches to the Unidimensional Relaxed Problem 101 8.5.1 The Direct Approach 101 8.5.2 The Dual Approach 102 8.5.3 The Hamiltonian Approach 103 8.6 The Hamiltonian Approach to the Unidimensional Complete Problem 105 References 107 9 The Multidimensional Screening Model 109 9.1 The Hamiltonian Approach and the First-Order Conditions 111 9.2 An Example 113 9.3 Exercises 115 References 115 Part IV Mechanism Design Applications to Islamic Finance 116 10 Business Loans, Trust, and Contract Restriction Faced by Islamic Banks 117 10.1 Model 117 10.1.1 The Optimal Contract for a Linear-Exponential Model 120 10.2 Comparing the Performance of a Conventional and an Islamic Bank 127 10.3 Bibliographic Notes 128 References 129 11 Loans Provision and Adverse Selection Within Orthodox Religious Communities 130 11.1 The Model 130 References 135 12 Shariah Compliance and Risk-Incentive Trade-Offs 136 12.1 A Simple Principal–Agent Model 136 12.2 The Principal–Agent Model Under a Mudārabah Contract 138 12.3 Social Norms and Risk-Incentive Trade-Offs 140 12.4 Bibliographic Notes 145 References 146 13 Shariah Compliance, Positive Assortative Matching and the Performance of IFI's 147 13.1 Costs and Benefits of Asset Restrictions 148 13.2 Positive Assortative Matching as a Magnification Mechanism 149 13.3 Bibliographic Notes 153 References 153 14 Optimal Incentives for Takaful Operators 154 14.1 Exercises 156 14.2 Bibliographic Notes 156 References 156 15 Can Short-Selling Prohibition Be Optimal? 158 15.1 Stable Distributions 159 References 164 16 Conclusions 165 References 168 Bibliography 169 Index 170 Front Matter....Pages i-xiii Front Matter....Pages 1-2 Introduction....Pages 3-29 Islamic Financial Instruments....Pages 31-47 The Historical Roots and Evolution of Islamic Financial Thought....Pages 49-51 Front Matter....Pages 53-54 The Incidence of Taxation....Pages 55-59 The Basics of Corporate Finance: The Miller–Modigliani Theorem....Pages 61-71 Front Matter....Pages 73-74 Game Theory....Pages 75-82 The Revelation Principle....Pages 83-84 Monopolistic Screening....Pages 85-101 The Multidimensional Screening Model....Pages 103-109 Front Matter....Pages 111-111 Business Loans, Trust, and Contract Restriction Faced by Islamic Banks....Pages 113-125 Loans Provision and Adverse Selection Within Orthodox Religious Communities....Pages 127-132 Shariah Compliance and Risk-Incentive Trade-Offs....Pages 133-143 Shariah Compliance, Positive Assortative Matching and the Performance of IFI’s....Pages 145-151 Optimal Incentives for Takaful Operators....Pages 153-156 Can Short-Selling Prohibition Be Optimal?....Pages 157-163 Conclusions....Pages 165-168 Back Matter....Pages 169-173