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Islamic Finance: An Introductory Course. Part-1 (Miller-Modigliani Theorem)


As some of you may know, I am enrolled in an Islamic Finance course at Wharton. The Professor, Michael McMillen is a renowned expert, with an impressive and diverse background (to say the least). He has a BBA, MD and JD in the bag. Some of his achievements:

He has twice been a recipient of the Euromoney award for Best Legal Advisor in Islamic Finance (2004 and 2007) and has also received the Sheikh Mohammed Bin Rashid Al-Maktoum award for Best Legal Advisor in Islamic Finance for North America. He is currently the Chair of the Islamic Law Forum, a division of the International Law Section of the American Bar Association

islamic-finance.jpgI will be covering the course-work through part of the Spring semester next year (my last semester, yoo hoo). So, I thought that as I studied this material, I would share it with all of you. I know there is a lot of interest in Islamic finance, especially in light of the current financial turmoil, and interestingly Islamic financial principles take a big stab at one of the main sources of the financial collapse, debt. I touched upon this in this article.

I have to caution you that some of the stuff may be a bit too technical, but it is not necessary to grasp every word of this. Rather, I hope to give a general understanding in the simplest terms possible. If you don’t understand something, ask, and I’ll try to answer (“try” is a key word, because I am hardly an expert on finance myself!)

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Before I embark on this journey with you all, I have been wanting to share an interesting learning from my core finance course last year. This is not part of the Islamic finance course, just something I found quite remarkable.

This revolves around the theory by two Professors, Franco Modigliani, Merton Miller, commonly known as the Miller-Modigliani theorem (M&M!) who won a Noble Prize for this. In fact, the theory itself is quite simple, and as we are learn several times in academics, many of the Noble Prize winners haven’t come up with ground-breaking new research, but rather summarized/clarified/put-in-a-nutshell what was already obvious, i.e. be able to explain a phenomena that everyone kind of already knew but couldn’t quite explain before!

Here’s what M&M proposed:

In the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. It does not matter if the firm’s capital is raised by issuing stock or selling debt. It does not matter what the firm’s dividend policy is. Therefore, the Modigliani-Miller theorem is also often called the capital structure irrelevance principle. [Wiki]

The point? Debt is irrelevant. In other words, debt, by itself does not create value. In fact, an individual could mimic a company’s debt structure and make the company’s decision irrelevant.

So, let’s say there is a company A that has 20% of debt in its capital structure (i.e. how the company is financed) with the balance 80% being equity (shares, etc.). There is another debt-free company B, with exactly the same operating performance as A (i.e. they both generate the same profits and have the same assets). An individual could then use 80% of his money to buy shares of company A, and borrow 20% from the bank, and essentially mimic company A (assume that interest rate is same for individual and company). So, in essence, B cannot differentiate itself from A by simply borrowing, because an individual investor could do the same. And then in a perfect market, where everything is known about A and B, arbitrage will prevent one company from being valued higher than the other. Miller said it best:

“Think of the firm as a gigantic tub of whole milk. The farmer can sell the whole milk as it is. Or he can separate out the cream, and sell it at a considerably higher price than the whole milk would bring.” He continues, “The Modigliani-Miller proposition says that if there were no costs of separation, (and, of course, no government dairy support program), the cream plus the skim milk would bring the same price as the whole milk.” The essence of the argument is that increasing the amount of debt (cream) lowers the value of outstanding equity (skim milk) – selling off safe cash flows to debt-holders leaves the firm with more lower valued equity, keeping the total value of the firm unchanged. Put differently, any gain from using more of what might seem to be cheaper debt is offset by the higher cost of now riskier equity. Hence, given a fixed amount of total capital, the allocation of capital between debt and equity is irrelevant because the weighted average of the two costs of capital to the firm is the same for all possible combinations of the two. [Read more here]

Okay, what’s the point? Why do I find this so interesting? The point is that it is taxes, or the deductibility thereof on interest that makes debt a tool for adding value. A firm that has a constant financial structure (debt:equity ratio constant), then its value with debt can be summed up as the following (in a state where interest is tax deductible):

Original Value: Vu  (the subscript “u” is usually for value of unlevered firm = a firm that has no debt, and “l” is the value of a firm that is levered or has debt)
Borrow an amount = D
Taxes = T
New Value of Firm: Vl = Vu + TxD

So, the value of a firm that borrows an amount “D” goes up by “TxD”. This is due to tax shields. Basically, interest is tax-deductible. If you pay any interest (which as Muslims we shouldn’t be), then you can subtract that from your income and basically save taxes. So, in essence there is a transfer of money from the government to you because you borrowed. And who benefits in the end? Yes, you benefit, but there is an ultimate winner, which brings me to the punch-line.

The banks are the ones who owe their economic viability and “need” on government subsidy

Now remember that a firm has to two claims against it, from its two sources of finance: the equity holders (shareholders), and the debt-holders (banks, etc.). Interestingly, while the dividends to shareholders are not tax-deductible, the interest to debt-holders is… even though they are both fundamentally returns on investment. Furthermore, the bond/debt-holders have first dibs on the money, so they get their money before any other class of financeers. And as I mentioned, all the interest that bond/debt-holders are paid, can be written off by the company, so that their after-tax interest rate is even lower. But they get no such benefit in giving dividends.

For instance, if a company has a 10% interest rate on a debt of $100. Then it has to pay $10 interest. But it can deduct that $10 from its income. If taxes were 50%, then the company now has to pay $10 x 50% = $5 less to the government. In essence then, while it paid $10 as interest, it paid $5 less to the government. So, in effect, it only gave up $5 from its coffers. Thus, its after-tax interest rate was really only 5% (which is tax times interest rate = 10% x 50% = 5%). Debt creates value for the company by reducing government claims to its income.

The entire system of tax-deductibility of interest actually has no real economic sense. I asked my Professor in class why the government would do this, what is the point? He said he didn’t really know, and he especially didn’t get the discrimination between interest and dividend in terms of tax-deductibility. But what is known is that the ultimate winners of interest tax-deductions are the banks. Remove the tax benefit, and banks suddenly become quite useless (according to M&M).

For Muslims, this is an intriguing conclusion. Banks, the source of so much riba, would be really quite useless if the tax rules for dividends and interest were either uniform (i.e. tax deductibility on both) or if there were no tax (like in an Islamic state). So, if perfect market symmetry existed, say in Dubai (where there is no tax), theoretically debt would add no value. Had we had no debt, wouldn’t we have been so much better financially in the world these days??

Next: Introductions, “what is riba”

Related Posts:

Image credit: Dinar Standard

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Abu Reem is one of the founders of MuslimMatters, Inc. His identity is shaped by his religion (Islam), place of birth (Pakistan), and nationality (American). By education, he is a ChemE, topped off with an MBA from Wharton. He has been involved with Texas Dawah, Clear Lake Islamic Center and MSA. His interests include politics, cricket, and media interactions. Career-wise, Abu Reem is in management in the oil & gas industry (but one who still appreciates the "green revolution").



  1. Faiza

    November 22, 2008 at 2:03 AM

    Assalamu alaikum wrb!!

    Maasha Allah, amazingly refreshing article on Islamic Finance. Looking for more!

    Jazakallahu Khair

  2. MM Associates

    November 22, 2008 at 2:04 AM

    [written by abu abdAllah]

    and hundreds of billions of our tax dollars are now going to bail out banks. hundreds of billions… — not even the same ballpark as the 25 billion the auto industry got (out of which how much went to their creditors? ie, banks?), and not like the 25 billion more that the auto industry may need now to stay afloat. after all the auto industry builds stuff, while the banks…


    jazak Allah khayr, Amad. i like reading articles from your scholarly persona. :)

    now if you had written an article about how the banks are keeping the single-brothers down, then maybe you could get 200 comments for this article, too… :P

  3. Abu Umar

    November 22, 2008 at 2:31 AM

    I dislike these terms “Islamic finance,” “Islamic banking,” “Islamic mortgages,” etc. These are often deceptive terms used be modernists to justify blatantly anti-Islamic economic practices. I think Muslims need to be very careful when dealing with these things. Though I don’t agree with him on other issues, ‘Abd al-Qadir as-Sufi (Ian Dallas) from the Murabitun movement has many good writings on economics and the modernist innovations which are an avenue for the international bankers to exploit the Muslim world.

  4. Naeem

    November 22, 2008 at 6:34 AM

    AA- Amad,

    Interesting article…(better than that single brother post…God help those single bros…lol)

    Not sure if I understood you correctly, so my question may not make sense, but here goes:

    “So, if perfect market symmetry existed, say in Dubai (where there is no tax), theoretically debt would add no value.”

    If its the western governments that make debt so attractive (via their tax laws), then how come banks are thriving in GCC countries where such tax laws don’t exist? According to the M&M theory, banks should be struggling in economies that don’t have debt-friendly tax laws, no?

    I’m guessing there are a host of so many other variables that play a role in making the banks a necessity in today’s economy

  5. Amad

    November 22, 2008 at 11:39 AM

    salam Br. Naeem,
    So, theoretically you are correct that banks would struggle in economies without tax. But that theory depends on perfect market symmetry and perfectly efficient markets. While that is getting closer to being the case in Western nations, it is not true yet of the Dubai stock exchange for instance.

    Also, banks become irrelevant for debt financing, but that also means that equity financing is available plentifully and easily. But that is not the case most of the times. That is why “true” Islamic banks would be providing loans as equity-holders rather than debt-holders, and that is in essence the crux of Islamic banking.

    Let me also mention that part of the reason that drives business owners to banks is also related to greed and “dhulm”. As Mufti Taqi Uthmani outlined in a lengthy dissertation on the prohibition of interest (inshallah, I will be summarizing that amazing paper in the future), while a company borrows, say 80% from the banks, the return it gives to the banks is like 5%. Dhulm goes both ways. And fixed-interest debt is cheap. The owners don’t want to share their prosperity. While the company doesn’t become more valuable because of debt, as long as the company is making more money above the cost of debt, then the rest of the equity holders are “milking it”.

    I’ll give you a private equity example. If I invest 10% in a company, with 90% borrowed. Let’s say the company was worth $1000, so my share is $100, the bank’s is $900, but I OWN the company. If the company now goes up to $1500 in price, I get to keep the gains of $500. So, now my profit is $500 on an investment of $100 less any small amount of interest. Thus my return is nearly 500%, and the bank’s return? About 10% or its interest rate.

    Let’s remember private equity companies were part of the leverage bubble… creating wealth (not all of it, but a lot of it) from financial engineering.

  6. Amad

    November 22, 2008 at 11:41 AM

    Abu Umar, hold your horses bro :) .. terminologies are just that… terminologies. No doubt there is a lot of abuse going on, but let’s not discount the whole concept. There are a lot of great scholars working this field. I hope I can help with shedding some light on this… and I am not sure where this is going to go… whether positive or negative. wallahualam.

  7. Al-Madrasi

    November 22, 2008 at 12:30 PM


    Good starting point to learn for a financially illiterate like me, looking forward to learn more…

    Barakallahu feek.

  8. Abu Umar

    November 22, 2008 at 1:04 PM

    Abu Umar, hold your horses bro

    I qualified everything I said.

    terminologies are just that… terminologies

    Well they aren’t just empty phrases or words with no meaning or significance. Terms are meant to express some idea.

    No doubt there is a lot of abuse going on, but let’s not discount the whole concept.

    Considering the widespread abuse of these usurious “Islamic” finance projects I am very wary of them.

  9. Pasha

    November 22, 2008 at 1:09 PM

    abu umar i completely agree with you, the article was interesting I want to see what the next one will say. Will it discuss. Musharaka, Murabaha, Ijaza etc.?

  10. Mezba

    November 22, 2008 at 1:34 PM

    It’s an interesting article – I was not aware of that theory that taxes play a big role in bank’s prominence.

    In Dubai, Islamic banks (or so-called Islamic banks) charge huge amounts of service charges etc. and have strict conditions on withdrawing money (for example Emirates Islamic Bank has a limit of 5000 Dh) for some type of accounts. To me it all seems they are playing with the rules – charging interest except only not in name.

    I had three questions which no one who matured in Islamic financing could answer thoroughly. The author seems to be knowledgeable in this aspect, maybe he can take an attempt?

    1) I want to lend Mira $5,000 (in 2008), and Mira has promised to pay me back $5,000 in five years (in 2013). Now we know inflation is a fact, value of money decreases every year. So $5,000 in 2008 is actually worth more than $5,000 in 2008 than 2013. So why should Mira not pay me more than $5,000?

    2 a) I have $100,000 to lend to Mira. What is my incentive for doing so, if I cannot earn anything back in interest (and, given the example in (1), actually lose money)?

    2 b) I want to borrow $100,000 to start a business. I don’t want to make anyone partners in my business, I just want to borrow the money and return it after so many years when my business is up and running. What incentives can I offer the lender if I am not paying them interest?

    3) If I am lending someone money, I am losing the opportunity cost of that money. If I lend Mira $100 for 1 week, I can’t use that $100 for 1 week. How will Mira compensate me for that 1 week?

  11. Al-Madrasi

    November 22, 2008 at 6:37 PM


    To answer your question 1) Since there is a depreciation for the currency, when you lend Mira $5000, get that days gold/silver/whatever value and convert your money to equivalent of gold/silver/whatever, and ask her to pay pack the same equivalent of gold/silver/whatever on the day Mira returns your money.

    Allahu Azzawajal knows the best.

    For your question 2 b) I think I have an affirmative answer heard from a scholar, but let me get that Hadheeth before answer.

  12. Siraaj

    November 22, 2008 at 7:40 PM


    For question #1, if you were to put that $5000 in a noninterest bearing account in 2008 and not touch it til 2013, would the bank give you back $5000 or what it is worth in 2013 terms?


  13. Amad

    November 22, 2008 at 8:01 PM

    Mezba, I am well aware of the time-value of money… but there is a different dimension that Islamic finance operates in. In fact, inflation is in part driven by an excess of money supply over money demand, because money is not backed by anything tangible anymore. And interest is all interlaced and part of the causes of inflation. So, in some sense interest drives inflation, and inflation then drives interest… its a vicious cycle.

    I hope to cover some of this when I get to summarizing Mufti Taqi’s opinions on this, which cover the fundamentals of the problem, not the symptoms.

    For now, the best way to overcome the inflation-based loss in time value, which would quite significant for 5 years, in your example anywhere from $700-$2000 (for an average US inflation of 3% to recent Dubai inflation of ~10%) is to buy a real commodity. Al-Madrasi has offered a good solution that I was also going to mention.

    As for incentives in lending, I think sometimes we fail to remember the concept of qardah hasanah, which is to give someone a loan in a time of need, and expect nothing in return. The return is ajar from Allah, which more than sufficiently compensates the loss in real value. So, there are more things in life than profit motives.

    I have already discussed a private equity example that covers some of the issues you brought up in your company example, i.e., about not wanting to share profits. This is the essence of what goes against Islamic principles, and leads to dhulm that can go both ways. And remember, while you don’t want the bank to share your profits, the flip-side is the bank won’t be too merciful when you are losing money either. Since they are only looking for a guaranteed loan, they really won’t care about the health of your business, as long as their interest payments are met. This drives bad lending practices as well, I think the US real estate bubble offers a good example.

    So, let me say that I have barely scratched the surface right now. There are many issues to discuss and many others to understand. A superficial knowledge of economics and finance can sometimes lead to misleading conclusions in one’s mind, which on the surface seem quite solid but could be fundamentally flawed. And I hope we can all learn together, because I have a lot to learn as well.

    Jak everyone for your support and questions.

  14. Amad

    November 22, 2008 at 8:02 PM

    Siraaj, a non interest-bearing interest would give you whatever you had in the first place. It would stay the same amount in nominal terms, and not adjusted for real-value changes. Not sure what your question around that is?

  15. Al-Madrasi

    November 23, 2008 at 1:10 AM


    A scholar responded to the question 2) b affirmatively by quoting the following Hadheeths

    Narated By Abu Huraira : The Prophet owed somebody a camel of a certain age. When he came to demand it back, the Prophet said (to some people), “Give him (his due).” When the people searched for a camel of that age, they found none, but found a camel one year older. The Prophet said, “Give (it to) him.” On that, the man remarked, “You have given me my right in full. May Allah give you in full.” The Prophet said, “The best amongst you is the one who pays the rights of others generously.” – Bukhari, Book 038, No. 501.

    He also quoted the following Hadheeth as well:

    Narated By Jabir bin ‘Abdullah : I was accompanying the Prophet on a journey and was riding a slow camel that was lagging behind the others. The Prophet passed by me and asked, “Who is this?” I replied, “Jabir bin ‘Abdullah.” He asked, “What is the matter, (why are you late)?” I replied, “I am riding a slow camel.” He asked, “Do you have a stick?” I replied in the affirmative. He said, “Give it to me.” When I gave it to him, he beat the camel and rebuked it. Then that camel surpassed the others thenceforth. The Prophet said, “Sell it to me.” I replied, “It is (a gift) for you, O Allah’s Apostle.” He said, “Sell it to me. I have bought it for four Dinars (gold pieces) and you can keep on riding it till Medina.” When we approached Medina, I started going (towards my house). The Prophet said, “Where are you going?” I Sad, “I have married a widow.” He said, “Why have you not married a virgin to fondle with each other?” I said, “My father died and left daughters, so I decided to marry a widow (an experienced woman) (to look after them).” He said, “Well done.” When we reached Medina, Allah’s Apostle said, “O Bilal, pay him (the price of the camel) and give him extra money.” Bilal gave me four Dinars and one Qirat extra. (A sub-narrator said): Jabir added, “The extra Qirat of Allah’s Apostle never parted from me.” The Qirat was always in Jabir bin ‘Abdullah’s purse. – Bukhari, Book 038, No 504.

    When he quoted this Hadheeth, scholar noted that Rasool (SAW) bought it as a loan and when he repayed Jabir (RA), he paid more.

    Btw, it is very clear in islam that lender should not force the payer to pay more, if the person wants to, he can give more than he owes, probably from the previous Hadheeth, “The best amongst you is the one who pays the rights of others generously.”

    Allahu Azzawajal knows the best.

  16. Mezba

    November 23, 2008 at 11:45 AM

    Thanks for the answers.

    As for qn 1, since there is deprecation for currency, I can tie the value of the $5000 to gold/silver/etc and get that value back in 5 years. So in essence, I am lending her the gold, not money. I like this answer.

    But for the other questions, I haven’t heard yet any acceptable answer. Keep in mind if I am a bank lending money to businesses I don’t really care about hasanah or rewards from Allah as I am a bank or corporation intending to make money. And under Islamic financing, I don’t see a way unless you are willing as a bank to become owner and accept liabilities.

  17. abu abdAllah, the Houstonian

    November 23, 2008 at 3:36 PM

    bismillah. amad, we may not hit 200 questions in this thread, but inshaAllah, there will be much more good in this thread and series’ questions and answers. :)

    @amad’s reply to siraaj — i think Siraaj’s reply was a rhetorical question aimed at the first question of Mezba asking about the loss of value. it points out that we are perfectly willing to have a bank give us back our deposits without any adjustment for inflation. what’s interesting to note, though, is that these bank deposits are returned on demand.

    so my follow-ups:
    (1) does shariah require a term for the loan? or does it comment on the value or detriment (for/to either party) of adding a fixed term to a loan?

    (2) an interesting component of any discussion of recapturing value is what restrictions does shariah put on what can be sold or contracted for? if two parties recognize some value that would be conferred or created by a transaction, are there any restrictions on monetizing that value and “selling” or “buying” it?

  18. abu abdAllah, the Houstonian

    November 23, 2008 at 3:47 PM


    @Mezba regarding your questions 2 and 3. more patience, please. i gather that Amad was trying gently to let you know that your premises about profit-sharing may need to be addressed first. and that would happen as the series progresses, inshaAllah.

    if a person presumes as many in this world do that the only rational motive is profit, then repackaging your questions, one might ask which (if any) transactions for profit are forbidden by Allah and why? in those terms it may become easier to understand that of course some transactions are prohibited (prostitution is just the most obvious one). and the why of each is clear or muddy depending on one’s knowledge and hiqmah.

    if i understood Amad, with this series we will gain a better understanding, inshaAllah, of what the scholars say about prohibited and acceptable financial transactions.

  19. Ahmad AlFarsi

    November 23, 2008 at 3:56 PM


    To my understanding, under the Islamic understanding of finance, a loan is meant to be a non-profit, philanthropic transaction, and the lender understands that he might be taking a loss when lending money.

    According to Islam, there is no commericial/money-making incentive for simply lending money… just as there is no commercial incentive for giving money in charity. The only incentive is the reward from Allah (just as in charity), and if the people in charge of corporation don’t care about getting reward from Allah, then they have much bigger issues. There is a hadeeth in which the Prophet sall Allahu alayhi wa sallam said that the reward for lending money is half of sadaqah (Sh. Isam Rajab explained this to mean that, for example, if someone lends $1000, they would get the reward for giving $500 in sadaqah).

    With regards to a business venture, the person who wants to start up a business, if he has no start-up money, will have no other choice but to make someone else (like the “bank”) a partner in his business, so instead of lending money, the bank becomes a joint-owner of the business along with the first guy. This way, the “bank” should be smart enough only to invest in business ventures that they expect to make money, because if there is actually a loss, then the investor takes loss as well, and if there is gain, the investor makes a gain as well.

    You said, “I want to borrow $100,000 to start a business. I don’t want to make anyone partners in my business, I just want to borrow the money and return it after so many years when my business is up and running.” Well, if you want to just borrow money without any business partners, you are in essence asking for the generosity of others, so it might happen, it might not happen, but you shouldn’t expect it. Rather, the person who wants to start up his business has to suck it up, so to speak, and realize that if he has not start up money, he really has to find an investor who will be a business partner. To EXPECT someone to just lend him money for his business venture, is really an unreasonable expectation, because, as I said earlier, a loan, in and of itself, is really an act of generosity, and, under the Islam, the lender doesn’t have a financial incentive for lending. He can inshaAllah expect reward from Allah for lending.

  20. abu abdAllah, the Houstonian

    November 23, 2008 at 4:16 PM

    bismillah. i think future articles in the series may shed much more light on these ideas, but to amplify different consequences of Ahmad’s reply, an entrepreneur who wants total control over his business but has no capital (or insufficient capital) may benefit tremendously from not being able to get a “purely for profit” loan.

    in the case of an inexperienced entrepreneur, one who has never been tried and tested, he will have to have a good business plan or at least have fully developed his idea to attract financing from investors. that is good for the whole society because it means capital is being allocated with forethought and deliberation. and it likely means the entrepreneur’s venture will be more successful, too.

    veteran entrepreneurs can establish complete independence without owing anything to the charity of others. that was the case for many Muhajir who declined the wealth offered by the Ansar in charity, and built back their own financial independence in the marketplace of Madinah.

    the vehicle in both cases is that the entrepreneur without capital contributes sweat-equity and the capital investors contribute exactly that, and the shariah discusses how they share in the profits.

    i think many people make the assumption that there can be no means for the investors to withdraw later, and no means for the entrepreneur to buy them out later, etc. those are all topics that i would be interested in learning more about from the perspective of shariah.

    and one thing that so motivates me to study shariah policies is that there can be no doubt that Islam fostered wealth-building. we are not just learning to be good Muslims when we study this topic. we are learning to be financially responsible and successful, inshaAllah.

    Islam did not make wealth evil or undesirable. it reminded humanity that hoarding is evil, that riba is evil, and so forth — and so far as i know — everything that Allah declared evil with regards to money is something that ultimately hurts the fiscal health of a society.

  21. Mezba

    November 23, 2008 at 6:35 PM

    Oh, I am willing to wait for all the questions to be answered, trust me, this has been a pet topic of mine! :-D

  22. Amad

    November 23, 2008 at 6:38 PM

    I think people forget that while it seems appealing to have a bank that takes his 5-10% and leaves the rest for the businessman, the same bank also has first and exclusive rights to your profits to get his 5-10% back. And if you don’t give him the agreed-upon percent each month, even if that is 1% less, the bank can take over your business, foreclose/liquidate it and get its money back, even if it only invested 20% of the total business financing. In fact, all the bank cares about is that the business sells for 20.1%, with 0.1% covering foreclosure expenses. The inherent dhulm (injustice) in this is clear. On the flip-side, there is also injustice when the business booms, and the bank (representing many depositors) gets only its teeny 5-10%.

    While we will see models of financing and “Islamic debt” called sukook, there is nothing in Islam that is risk-free. There is always an element of risk, no matter how small. And there is usually some element of profit and loss sharing.

    Let’s remember that money was never meant to act as a commodity, to be bought and sold for profit, rather it is a means for the exchange of goods. It was meant to be the means, but it become an end in “financial engineered” products. There is a reason why we have a crises. Let’s not assume that the current status quo is where we need to find the solutions, and then if seeing none, assume that Islam is the problem. Rather, for decades upon decades, Islam was shut out of economics and commerce (due to American and British imperialism) and interest-based systems were shoved down our throats. It is only recently, in the last 30 years, when ijtihad in financial and commercial issues has reopened, and Islamic systems are being developed. So, let’s be patient with Islamic finance in general, and with me in specific for sharing what I learn :)

    P.S. Another reminder: I am not an expert, or going to be an expert in this subject, I am merely a student who is sharing some of his learning. So, be prepared for incomplete answers and mistakes too!

  23. Faiza

    November 24, 2008 at 2:20 AM

    I have seen similar questions raised by a person in an orkut forum on Islamic Finance.

    As it is being quoted repeatedly by some of our brothers in this thread, when one lends, he performs an act of genorosity expecting nothing in return. A lot of us forget this and raise the same issue as Non Muslims- ‘opportunity cost of lending’.

    I am quite frustrated with how the interest based financial system works. The moment I say interest is forbidden in Islam, the next question that comes up is ‘how will I be compensated for the loss of value of my money’ or simply ‘doesnt Islamic Banking ignore the Time Value of Money’?

    Well, if one would see, the ‘concept’ Time Value of Money is based upon the assumption that one gets a fixed return for his money for a particular period of time, which is nothing but interest.

    Does the value of money really erode over a period of time? What is the measure that one uses to know whether the purchasing power has really gone down or not?

    For a poor man, his purchasing power is determined by his ability to buy grocery for a family. For him, increase/decrease in the prices of houses, electonics and automobiles will make NO difference
    For a person in the middle-class, it is his ability to pay rent, buy a bike, etc apart from groceries. He will be affected by the price increase of groceries, but not to the extent of the poor man
    For a richer person, it may be something else-like buying a house in a posh area and he is not necessarily affected by the increase in the prices of essential commodities

  24. Ibn Mikdad

    November 24, 2008 at 9:53 AM

    I don’t like Ian Dallas and his ilk too much either, but with regards to gold, they seem to be on to somethinga, if we were to trust this piece from WSJ:

    I picked the sotry up back at Rod Dreher’s blog; this is his very short post on the issue:

    “Was Ron Paul right about the gold standard?

    Remember how everybody laughed at Ron Paul for saying that going off the gold standard was the beginning of the end for the US economy? Well, the Wall Street Journal today has a column by Christopher Wood saying that the Federal Reserve is just about out of ammunition for fighting off the economic crisis, and that the ultimate result of all this will likely be a dollar collapse and, well…:

    ” In this respect the present crisis in the West will ultimately end up discrediting mechanical monetarism — and with it the fiat paper-money system in general — as the U.S. paper-dollar standard, in place since Richard Nixon broke the link with gold in 1971, finally disintegrates.

    The catalyst will be foreign creditors fleeing the dollar for gold. That will in turn lead to global recognition of the need for a vastly more disciplined global financial system and one where gold, the “barbarous relic” scorned by most modern central bankers, may well play a part.”

  25. Ibn Mikdad

    November 24, 2008 at 9:59 AM

    I apologize for the spelling errors, I’m in a bit of a hurry…

  26. Amad

    November 24, 2008 at 10:48 AM

    Ibn Mikdad, very interesting article. I’d like to take this opportunity to provide a short macro-econ intro on money supply for those interested:

    In macro econ terms, inflation is caused by a combination of effects: money supply, “velocity of money”, and real GDP:

    ∆P/P = ∆M/M + ∆V/V −∆Y/Y (where ∆ stands for delta or change)

    The left-hand side represents changes in price over base price, i.e. inflation. The right hand side consists of change in money supply (∆M/M), change in velocity (∆V/V) and change in real GDP (∆Y/Y)

    The Fed reserve can only affect the money supply, as the WSJ article correctly points out, and it does that by:
    ΔM/M = Δmm/mm + ΔMB/MB

    mm is a money-multiplier and depends on how much the banks multiply monetary base (MB). So, the Fed controls amount of the monetary base. It does so by selling or buying treasury stock. As it buys treasury stocks from, banks, it pumps more money in the MB. If things are working “normally” the multiplier is usually constant, i.e. IF things are working normally. For the average US multiplier, each dollar in the MB is to be loaned out such that 10 dollars are “created”. You can read more on this fascinating “scheme” here. As we know recently, banks are not really lending to each other. So, the multiplier is probably suffering. We saw this in Japan. The following is a tid-bit from my macro notes about deflationary pressures in Japan::

    In Japan, though the monetary base grew at a 10 percent annual rate from 1999 through 2005, the money supply (M2) grew at a 2.2 percent annual rate; thus the money multiplier in Japan declined at a rate of 7.8 percent per year

    The article talks about velocity. Velocity of money is a measure of how often the average dollar changes hands in a year. As velocity goes down, it also puts deflationary pressures. See the first equation.

    Bottom-line, money “creation” sometimes doesn’t work as intended. And when it does work, inflation is supposed to be good. And the whole interest-inflation cycle comes into play. Having some sort of backing for the money may help stabilize things. Stopping the use of money as a commodity is the ultimate answer of course, one that our deen backs!

  27. Mezba

    November 24, 2008 at 10:55 AM

    Money’s value DOES erode over time. Inflation is a rise in the general level of prices of goods and services in an economy over a period of time.

    In Canada, there is an index called CPI (Consumer Purchasing Index) which samples a bunch of goods and services used by the average Canadian to measure inflation over time. So time value of money is not entirely based on interest.

  28. Amad

    November 24, 2008 at 11:13 AM

    Mezba, I didn’t say that.

    Some food for thought: What is the fundamental reason for general level of prices of goods and services to rise? Are their inherent values increasing? Are we getting more out of the loaf of bread now than we got 50 years ago? What causes inflation then?

    I have given you some background on inflation in my previous comment. How inflation and interest interplay is a topic for the future.

  29. Mezba

    November 24, 2008 at 12:07 PM

    I was replying to Faiza’s comment above.

    One of the causes for inflation (other than excess money supply which is tied ot interest) is that consumers when they become better off can afford to pay more for goods and services, so suppliers raise the prices. It’s for this reason during a recession you see gas prices fall and so on.

    It would be an interesting experiment if the government for example forbid personal loans over $50,000. Will we see house prices come down then, as no one can pay? Some commodities (such as property prices in Dubai, for example) are artificially high.

  30. Ahmad AlFarsi

    November 24, 2008 at 2:18 PM

    the bottom-line is that since lending is a non-profit, charitable act, the lender assumes that he might incur a loss due to the depreciation of the currency in which the loan was made. If he really wants to try avoid that loss, as others have said above, he can purchase a real commodity, such as gold, lend out that amount of gold, and ask the borrower to pay him back the same weight in gold. There may still be depreciation… or there may even be appreciation of the value of gold (so then the lender actually gains), but, in any case, he gets paid back exactly what he lent.

  31. Faiza

    November 25, 2008 at 12:13 AM

    We have CPI and WPI eveywhere to calculate inflation. Here in India we had inflation (calculated based on WPI) that rose up to as high as 12% this year and now came down to somewhere around 8%. But the prices of necessary commodities do not directly reflect this variation and the prices are still high.

    The issue that I raised is to think what determines the value of money or the purchasing power, which may be different for different people. For a richer person, a 10% increase in his grocery bills is not going to make much difference, but it will make lots for a person with a lesser income. We see gadgets becoming cheaper and grocery dearer day by day.

    Apart from buying and selling treasury stocks, the Apex bank of a country may increase/decrease the interest rate in order to control the money supply. Though not entirely, inflation is largely influenced by interest.

    Brother Ahmad AlFarsi, I agree with your summary. But of late the prices of gold has been fluctuating like anything, there has been a 10% variation in a period of just 3 weeks. Just a day before Eid, the price climbed 8% in a day. What do we do in that case?

  32. Ahmad AlFarsi

    November 25, 2008 at 12:21 PM

    again, it comes back to the loan being an act of charity, so if you incur a loss (even of a real commodity), due to the fluctuation of the value of that commodity over time, it is reasonable, as you had expected that you might incur a loss before engaging in this charity.

  33. hk

    November 26, 2008 at 12:53 AM

    i was trying to gather in-depth info on riba (and islamic finance in general) for a non-muslim friend… and you know, there is virtually nothing out there? looking forward to that post, inshaAllah.

  34. Faiza

    November 26, 2008 at 2:43 AM

    Agreed, brother! Jazakallahu Khair..

  35. abulhassan

    November 27, 2008 at 5:45 AM

    THIS IS REALLY GREAT. Jazakum Allahu khair Amad…..Keep it coming!!!!

  36. Gohar

    November 27, 2008 at 1:02 PM

    I’m struggling with most of this, I admit. For now can you help me understand where I am going wrong with the milk tub analogy.

    In my mind, if the cream is a desired item and therefore worth more sold as cream than as part of whole milk, then selling seperate items of cream and skimmed milk should be worth more than the value of whole milk as a single product (assuming that that skimmed milk isn’t worth any less than whole milk, of course). But the analogy is saying that it should bring the same price.

  37. Amad

    November 27, 2008 at 1:34 PM

    Gohar, let me say it differently then. If you have a bag of mixed quality/value nuts, lets say cashews, almonds and peanuts. Cashew being more expensive than peanuts and almonds. Now, what if you remove all the cashews. The remaining price of the almonds and peanuts mixture would be lower. So, by taking the expensive stuff out, you have lowered the price of the remaining mixture. And if the market is efficient and prices of almonds, peanuts and cashews are fixed and known, then separating cashews out will give you the price of almonds and peanuts. Ultimately, you have not added any value, but just separated a more valuable component out.

    As for the skim milk and cream. When you take the cream out, the price of the skim milk actually goes down (it HAS to be less than the price of the whole milk– if it was not, then everyone would buy whole milk, separate skim milk and cream out, and make lots of money… so there is arbitrage opportunity that should not otherwise exist in a perfect market). So the price of skim milk + cream remains equal to the price of whole milk (we are of course assuming that separation costs are zero). By separating the cream out, you have made the remaining “left-over” less valuable, with total value remaining constant.

    When companies add debt, the banks/debt-holders have FIRST rights to the company’s cash flows. So, it makes the risk of the equity-holders who are next in line higher, and thus the rate of return they demand higher. The higher the rate of return demanded, the lower the value of the investment. If I go further along on return/risk, I think things will get confusing. So, I hope you understand the analogy at least.

  38. amazed

    May 30, 2009 at 1:39 PM

    to the author:
    Asalam Alaikum. Can you please advice on the following matter?

    My bank is offering a ‘Mudaraba account’ which requires me to deposit money from my current account to this account. The benefits are:

    1) annual profit that changes as per the assets of the bank . Thus relating the profit to the profit from the shariah compliant activity that the bank claims it earns it from. Hence not fixed like Riba.

    2) I can withdraw the cash and deposit in this account just like my current account.

    Please tell me if i will still be indulging in riba? Thanks

  39. Muhammad Saeed Babar

    November 13, 2010 at 1:12 AM

    MM theorems are nothing more than deception. They just pointed out that capital structure is relevant but said in a very provocative way ” under certain assumptions, it is irrelevant how the firm is financed”. How two firms’ EBIT can be same with different debt equity ratio. Let’s suppose Firms A & B are identical in all respects except debt equity ratio. Firm A is financed by 100% equity whereas Firm B is financed by 50:50 Debt Equity ratio. Firm B has to have greater EBIT than Firm A to be on the same footings as Firm A. Because firm A has no obligation to earn enough to cover for interest expenses whereas it is obligatory on firm B to make sure to earn enough to cover for interest as well as something for equity holders.

    So on theoretical fronts even the MM theorem I has no validity. There is no mention of this caveat in their writings. They simply assumed that EBIT to be enough to cover everything and be same for both firms whereas this is not the case.

  40. Muhammad Hanif

    April 25, 2011 at 4:34 AM


    Hoping for your best of health, faith and happiness.
    I am pleased to introduce my book on Islamic Banking.

    This book is result of 3 years teaching and course development for MBA Students in this area. I am confident this book addresses the questions generally raised by learners of course. This book is written in financial perspective (generally resources available are about Islamic commercial laws). This book contains summary of Islamic financial laws as well as financial impact generated by application of these laws. I hope this book will be used as text by teachers of finance in universities and learning centers around the world.


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