Re. ‘IB&F’ Observations of Professor Dr. Muhammad Anwar (P-III):

Introduction:               Professor Dr. Muhammad Anwar at that time with Department of Economics at ‘International Islamic University of Malaysia’ (IIUM) read a paper on ‘Islamicity of Banking Modes of Islamic Banking’ (IBMIB) on October 31, 2000. The link to aforesaid this 18-page document is given below. For the convenience of readers, this author has humbly highlighted the some important observations made by Professor Dr. Anwar with regards to ‘IB&F’, which will be reproduced in parts and the third part is given below.

https://lnkd.in/fw7Dy3p

Reproduction of an article by Professor Dr. Muhammad Anwar

‘Islamicity of Modes of Islamic Banking (Part – III):

4.0              Islamicity of central banking

Whenever a government runs a deficit, there are two methods to finance it. These are: (i) borrowing by issuance of additional government bonds and, (ii) printing additional high-powered money. The choice between borrowing and money creation is made by the central banks. The central banks issue fiat money that acquires the status of high-powered money. Fiat money is the money that does not represent a claim to any physical commodity but instead is backed by laws that require money to be accepted in all legal transactions (Farmer, 1999, 186). When more high-powered money is issued, nominal money supply grows and that, in turn, increases aggregate demand in the economy. Expansion of money supply through bank advances leads to a situation of too much money chasing too few goods. This excessive demand for goods turns into growth of output and prices. How the increased demand influences the output growth and inflation depends on the elasticity of the supply of goods and services. If the supply is completely inelastic then all the money supply growth turns into equivalent inflation. This is apparent from the classical quantity theory of money (Cobham, 1998, 54-56).

The quantity theory of money can be stated as follows:

 MV = PQ                                           …. (1)

Where, M stands for quantity of money supply, V for velocity of circulation of money, P for the price level and Q stands for real output. Equation (1) is an identity that shows that

quantity of money times the velocity of money must equal to the price level times the real output.

The same equation, in growth terms, can be re-written as:

^M + ^V = ^P + ^Q                                                        …. (2)

Equation (2) shows that sum of the growth rates in money supply and velocity of circulation must equal to the sum of growth rates of prices (inflation) and output. Assuming no change in the velocity of circulation, any growth in money supply due to printing action of a central bank will be translated into inflation and growth in output. If all the growth in money is translated into growth in output only, then the increased output is transferred to the central bank. Otherwise the government would get people’s property to the extent of the “inflation rate times real high-powered money” (Gordon, 2000, 385). This transfer to the state is called seignorage, and is also known as inflation tax. Seignorage is defined as the “difference between face value and intrinsic value of money” (Anwar, 1987, 295). It results from expansion of money supply because the real value of currency units held by the public reduces due to inflation. In other words, seignorage represents transfer of ownership from the holders of money to the creators of money because of inflation.

Injection of fiat money directly creates seignorage (inflation tax) to the government and so transfers real property of unaware people to the state authorities. Channeling of public funds to the authorities by foul means is in direct violation of Allah’s command “do not eat up your property among yourselves by foul means nor channel it to the authorities … wrongfully and knowingly”(al-Baqarah, 2:188). Therefore, it is obvious that the institution of central banking cannot be Islamic because it violates the express Qur’anic verdict regarding wrongful channeling of peoples’ property to the authorities.

Money is whatever people accept as a general medium of exchange. “The prophet of Islam is reported to have said that Allah has created gold and silver to be the natural money[1]” (PLD, 2000, 482). Central banks channel public property to the government coffers by creation of fiat money. As paper money issued by the governments is invalid, it is up to the people to revert to a valid form of money. If people wish they might revert to use of gold and silver as money. In fact, moving from fiat money to gold and silver will also prevent diversion of peoples’ property to the authorities by foul means.

Central banks also contribute to accrual of seignorage to the commercial banking system when they borrow money from the commercial banks by issuing bonds to meet budget deficit requirements of the state. As governments borrow money on the basis of interest, debt servicing leads to increase in budget deficits. This necessitates, again, issuance of more high-powered money and further borrowing from the banking system[2].

Seignorage accrues to the state according to the fiat money created by the central banks. Incidentally the same fiat money, being high-powered money, becomes basis for deposits and seignorage for the commercial banking system. In this way, not only central banks themselves violate the Qur’anic injunctions; they are also responsible for sowing the seeds for the wrongful growth of seignorage that accrues to the commercial banks. How it happens, is elaborated in the next section.

5.0             Islamicity of commercial banking system:

Banking has grown because of: (i) a fraction of the deposits is kept as reserves to meet withdrawals by the depositors and (ii) acceptance of receipts in lieu money (Farmer, 1999, 184-87). Suppose[3] someone deposits $100 of cash (high-powered money) into the banking system. Assuming that the depositors rarely withdraw more than 10% of their deposits, the bank decides to keep reserves equal to just 10% of total deposits and grants loans equal to the remaining 90% percent of total deposits. This depositing and lending the high-powered money starts the process of money creation by the commercial banks. Suppose the merchant from whom the borrower bought the merchandise redeposits the $90 into a bank. This raises total deposits to $190 and the bank again has the $100 in cash. Keeping 10% of all deposits requires the banks to retain $19 as reserves, the remaining $81 can be loaned out by the banks. The banks can continue retaining 10% of total deposits in reserves form and loaning the rest of it. This process can continue until total deposits equal $1000 and all the $100 cash (being10% of total deposits) is withheld by the banks as reserves.

However, four conditions must hold for the banks to turn $100 of high-powered money into a money supply of $1000. These conditions are: (i) bank deposits (i.e. checks) must be accepted as means of payment, (ii) Any consumer or business firm receiving a cash or check payment must deposit it back into the banking system, (iii) the bank must hold some fraction (e.g., 10%) of its reserves in the form of cash, and (iv) businesses and households must be willing to borrow whatever amount the banks want to lend. (Gordon, 2000, 428)

The money creation process can mathematically be expressed as follows:

     D = (H/e)         (3)

Where, H stands for amount of high-powered money, e for the reserve-holding ratio of commercial banks and D for amount of deposits (that become money supply). The ratio (1/e) is called money creation multiplier. The multiplier tells us by how many dollars the money supply will expand for every dollar of high-powered money deposited into the banking system. Of course, value of the multiplier in reality depends on several factors. However, one principle is obvious: lower (higher) the reserve ratio, higher (lower) the money supply and so the concomitant seignorage for the banking system. For example, if e = 0% then the multiplier would be infinity. This means that even one dollar deposited into the banking system has a potential to stretch into an unlimited amount of money, at least in theory. That is why the central banks impose required reserve ratio that curtails unlimited power of the commercial banks to create money supply[4].

If e = 5%, then multiplier equals twenty (20). That means every dollar deposited will expand into twenty (20) dollars out of which 19 dollars go to the coffers of the commercial banks. These nineteen dollars accrued to the banking system are referred as seignorage in the literature. If the banking system can own 19 dollars for each dollar of deposits then imagine how much of peoples’ wealth goes to the coffers of the commercial banks due to entire amount of deposits. The expanded money supply resulting from depositing of the high-powered money comes under ownership of the banking system. How much of this goes to each bank depends on the reflux ratio, percentage of each bank’s loans that are re-deposited into the same bank, of each bank (Jaffee, 1989, 339).  This is definitely a wrongful devouring of people’s property by the commercial banking system which contradicts the repeated command “do not devour your properties among yourselves through false means” (al-Baqarah, 2:188; Nisaa, 4:29)

This seignorage has two consequences: (i) bankers acquire ownership of the wealth to the extent of the seignorage without corresponding delivery against it and, (ii) increased money supply is responsible for increased inflation that causes a havoc in the society.

This seignorage would accrue to the banking system even when loans are advanced at a zero rate of interest. Whatever the banks earn in the form of contractual interest or profit is over and above the seignorage amount. Would banks advance loans if there were no interest charge on the loans? As the seignorage will accrue to the banks even if the advances were made free of charge, the absence of interest would not intimidate banks from lending money because otherwise they will loose their share in the seignorage.

Supporters of Islamic banking in the ranks of fuqaha, economists, bankers, and others mainly focused on the interest-based transactions as deals between banks and their clients. This outlook, perhaps inadvertently, led to the negligence of the larger issue of the legitimacy of the banking system itself. The banking system representing the institutional arrangements for collecting deposits and making advances in a fractional reserve system is in violation of the explicit Qur’anic verdict that forbids devouring of peoples’ money in the following words “O’ believers, do not eat your properties among yourselves through false means” (Nisaa, 4: 29)

Accrual of seignorage to the banking system depends on several factors (Gordon, 2000, 428) that are determined by the attitude and behavior of public toward the banks. If there were no deposits into the banking system then there would be no seignorage for the banks. Even if the people deposit but they do not borrow then, again, there would be no seignorage. If people borrow but do not redeposit their borrowings into the banking system then, again, there will be no seignorage. In a nutshell, accrual of seignorage to the banking system is in the hands of the public. The banks cannot accumulate seignorage if the people do not provide opportunity for it. It is the attitude of people that opens up opportunities for the banks to behave greedily and dishonestly.

Suppose all the money created by the banks is translated into real growth so that there is no inflation and no reduction in the real value of deposits. Then do the commercial banks have any advantage? Yes, because they being the creditors still become owners of the deposits created through this process. Therefore, inflation or no inflation the commercial banks would enjoy undue advantage thanks to the money expansion multiplier process. The government enjoys similar advantage when money supply is increased by the central banks as it acquires ownership of the peoples’ property in exchange to the tune of the money so created. The difference being the central banks directly create money while the commercial banks create money indirectly through the deposits.

If all the depositors turn to banks to withdraw their deposits then would they be able to receive back their deposits? Surely not because of the fractional reserve system that grew out of the dishonest practices of the early goldsmiths with whom people used to keep their trusts. Therefore the Allah’s orders like “Allah commands you to render back your trusts to those to whom thy are due” (Nisaa, 4: 58) and “do not misappropriate knowingly things entrusted to you” (Anfaal, 8: 27) can never be complied in the presence of the fractional reserve system. Moreover, due to expansion of money supply by the banks, the resulting inflation means that real value of the deposits falls. This means that the deposits withdrawn from the banks have diminished value. This amounts to a clear violation of not only the above commands but also of those commands that require to “give not short measure or weight” (Hud, 11: 84) and “give full measure and full weight” (Hud, 11: 85).

Accrual of the seignorage to the commercial banks by devaluing the money holdings of people through inflation necessarily favors concentration of real wealth into few hands, an outcome contrary to the Qur’anic command that wealth “does not make a circuit among the wealthy among you” (al-Hashar, 59: 7). The tendency of concentration of wealth into few hands is due to the seignorage that would happen even if the loans were issued at a zero rate of interest. Therefore, credit system imposes a larger problem compared to the practice of interest.

6.0              Measures towards enhanced Islamization of banking

It is clear from the above analysis that central banks provide high-powered money whereby they devour peoples’ property wrongfully. The high-powered money is the genesis for the deposits made by the people to the commercial banking system. The commercial banks advance those deposits to needy individuals and businesses and so they reap benefits in the form of implicit return (seignorage) and explicit return (interest or profit) on their credit. Both types of returns are found to be inconsistent with the commands of Allah. Therefore, further Islamization is needed in: (i) creation of fiat money by the central banks, (ii) creation of money supply by the commercial banks and (iii) elimination of riba component from the Islamic banking transactions. Therefore some measures are presented below which, if implemented, would enhance Islamization of banking. 

To be continued (refer; Part – IV)………..