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This book is based on the author's doctoral thesis submitted to Boston University. For review purposes the book can be divided into three parts. The first part comprises two chapters: the introduction and a chapter on the prohibition of Riba and the rationale behind this prohibition as asserted by various Muslim jurists. He briefly describes the Islamic alternatives to Riba with some emphasis on the Mudarabah type of financial contract. This part serves as a background to later analysis in the book. The second part of the book constitutes the back-bone of this study and consists of chapters three and four. In chapter three, the author develops an analytical framework that enables him to compare the two schemes, namely, the Islamic Variable Return Scheme (VRS) versus the conventional Fixed Return Scheme (FRS). Given the absence of informational asymmetry in the credit market, the author attempts to show the superiority of the Islamic model. Chapter four is devoted to explaining that given the superiority of the Islamic scheme, why the Fixed Return Scheme (FRS) actually dominates the credit market. The author argues that this dominance in the real world is explained by the presence of `Moral Hazard' in the credit market. Part three comprises one chapter which summarizes the contributions of Islamic economists who devoted their efforts to the development of models of interest-free financial intermediation. Two appendices and index are included at the end of the book, and a bibliography is provided at the end of each chapter.
A number of significant theoretical contributions in the last decade have shown that an interest-free system is potentially superior to the traditional interest-based system. We can cite Ziauddin Ahmed, Munawar Igbal and Fahim Khan (Money and Banking in Islam); Mohammed Arif (Monetary and Fiscal Economics of Islam); Umar Chapra (Towards a Just Monetary System); and M. Uzair (Interest Free Banking) among others. However, while most of the other studies have relied mainly on equity considerations, Khan's work, Towards an Interest-Free Islamic Economic System tries to show that even on grounds of pure efficiency, an interest-free financial system performs better than the one based on interest.
In the first part, the author discusses different types of Riba and their prohibition in Islam by referring to the verses of the Holy Our'an and the traditions of the Prophet Muhammad (peace be upon him). He also mentions the negative implications of Riba on the individual as well as on society. In addition, he gives a brief description of the Islamic alternatives to Riba which he classifies into two categories: (i) Shirkah (partnership) and (ii) Muqarabah (Agency relationship) giving more emphasis to the second type. Unlike Shirkah, there is more uniformity of treatment among Muslim jurists regarding the conditions of Muqarabah contract.
The second part, which constitutes the core of the book, comprises two chapters. In the first one, the author sets up a model that allows him to compare the variable return scheme (VRS) with the fixed return scheme (FRS). The results are derived under the absence of informational asymmetry in the credit market and the assumption of risk aversion on the part of investors. The Islamic variable return scheme (VRS) turns out to be superior to the fixed rate scheme. In the second chapter of this part, the author argues that the dominance of the fixed rate scheme (FRS) in the real world is due to the presence of 'moral hazard' in the credit market. This part focuses on developing an analytical framework that permits the choice of a financial contract in the presence of informational asymmetry in the credit market. A simple two-person non-zero, non-co-operative game theoretical model has been constructed to analyze the optimal behavior of the lender and the borrower using the Nash-Equilibrium concept. This model, which is a variant of the Principal-Agent model, helps monitor the behavior of the agent when monitoring costs are not prohibitive. Consequently, a financial system based on the principle of profit/loss sharing would force financial institutions to invest part of the society's resources in a non-productive activity the sole purpose of which is to monitor the activities of the borrowers. These information costs which are a deadweight loss to the society have to be weighed against the risk-spreading benefits of a profit/loss sharing system.
In part three, the author discusses the working of several models of an interest-free financial system, including those of Siddiqi, Uzair and Ahmed. The author compares the implications of his model with the model of the Islamic financial system as developed by the above Muslim economists. In addition, some comments on the feasibility of his model are made. Finally, a brief overview on Pakistan's experience is given. The discussion focuses particularly on Banker's Equity Limited, a financial institution which has introduced various Islamic financial schemes.
The book is a very useful addition to the literature on Islamic economics. However, we would like to point out some of our reservations about some analytical aspects of the book. First, from the technical side, there are serious deficiencies in the mathematical formulation of certain definitions which play an important role in the model developed by the author. More precisely in chapter three (e.g. p. 38), the definition of the lender's pay-off as well as that of the investor's pay-off under the fixed-rate scheme are not consistent with the idea described by the author just above. Moreover, the statistical formulation of their distributions is not well defined (e.g. p. 40) and the mathematical definition of the probability of monitoring a given reported return lacks rigor. These are some of the technical deficiencies which may alter the findings of this study. Second, the issue of informational asymmetry has been somewhat over-emphasized in this study. Informational asymmetry represents only one dimension of the problem and is significant only for single period models as observed by the author himself. In a longer run context, the investor is tied to the financial institution and hence cannot afford to under-report the performance of the project beyond a negligible level. Furthermore, under-reporting which is considered as `cheating' can also be challenged in court in the case of a Mudarabah contract.
Third, another dimension in this study, which in my opinion is as important as the problem of `moral hazard', if not more, needs to be acknowledged. As a matter of fact, the lender is often faced with projects which are not potentially feasible because the mechanism in place cannot detect their infeasibility at the time of the deal. This new dimension can be analyzed using the framework of `Market of Lemons' or that of `Economics of Signaling'. Despite these reservations about the analytical treatment, this book represents a useful contribution and deserves commendation. One hopes that additional works of this type will-be forthcoming as an interest-free Islamic economic system makes further progress.
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