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40 Diamond, D. W. (1984). “Financial Intermediation as Delegated Monitoring: A Simple Example”, Review of Economic Studies, 51(3), 393–14.
41 Ahmed, A. (2010). “Global Financial Crisis: An Islamic Finance Perspective”, International Journal of Islamic and Middle Eastern Finance and Management, 3(4), 306–320.
42 Chapra, M. U. (2007). “The Case against Interest: Is it Compelling?” Thunderbird International Business Review, 49(2), 161–186.
43 Chachi, A. (2005). “Origin and Development of Commercial and Islamic Banking Operations”, Journal of King Abdul Aziz University: Islamic Economics, 18(2), 3–25.
44 Thomson Reuters (2018). Islamic Finance Development Report. Salaam Gateway.
45 Global Islamic Finance Report (2019). Global Islamic Finance Report. London: Edbiz Consulting Group.
46 Demirgüç-Kunt, A., Klapper, L. et al. (2013). Islamic Finance and Financial Inclusion: Measuring Use of and Demand for Formal Financial Services among Muslim Adults. Policy Research Working Chapter No. 6642.
47 Naceur, S. B., Barajas, A. et al. (2015). Can Islamic Banking Increase Financial Inclusion? IMF Working Chapter, WP/15/31.
48 The Economist (2017). Africa is Islamic Banking’s New Frontier. Print Edition, July 13, 2017.
49 The Economist (2018). Why Non-Muslims Are Converting to Sharia Finance. Print Edition, October 20, 2018.
Chapter 2
Islamic View on Capital Allocation
2.1Islamic View on Interest as Price of Capital
In modern mainstream economics, the definition of physical capital stock implies that it includes “produced means of production”. Some examples of physical capital stock in contemporary businesses include equipment, tools, machinery, buildings, furniture, infrastructures, installations, and production plants.
As per the definition of physical capital stock, it does not include money capital. However, since there is interest-based banking operating everywhere, the opportunity cost of buying physical capital stock with money capital is considered to be the market interest rate forgone on an alternate interest-based investment of money capital.
The cost of using physical capital stock in the production process is the real interest rate plus the depreciation rate. The real interest rate is the opportunity cost of using money capital in buying the physical capital good. If the interest rate on money capital investments is 10%, then it is considered that the physical capital investment should yield at least 10% for it to be a comparatively better investment decision. Else, if physical capital investment yields a lower return than the return expected on money capital investment, then a rational investor taking into account only the self-interest shall choose money capital investment over physical capital investment in the production process. The argument goes as follows. If an entrepreneur has an option to invest $1,000 with a bank and earn 10% rate of interest on it, then the $1,000 invested in buying equipment for the production process should generate a minimum of 10% return for the justification of efficient allocation of resources.
Apart from the real interest rate, the other component in the user cost of capital is the depreciation rate. It is the rate per period at which there is wear and tear in the physical capital good when it is used in the production process for a period.
The user cost of capital per period as explained by Hall and Jorgenson1 can be expressed as follows:
where UC represents user cost of capital, Pk represents the price of physical capital stock, r represents the real rate of interest, and d represents the rate of depreciation.
Even from the perspective of economics, there are several issues in interest-based financial intermediation. It creates distributive inequity, concentration of wealth, limiting potential investments and as a result it may give rise to unemployment, financial exclusion, rising income inequalities and even ecological imbalances when producers strive hard to pay off debts without considering the external social costs of their operations on the environment.
Since collateral based lending in interest-based financial intermediation mostly entertains large scale businesses, they are able to gain scale advantage and beat the competition from the smaller entrepreneurs. With a greater degree of pricing power in imperfect markets, the producers pass on the cost of capital to the consumers by raising the prices. This fuels inflation in the economy which is not driven by real variables or supply shocks. Rather, it is the result of providing risk free return to the money capital in the economy. Thus, the cost of interest is also by and large paid by the consumers.
Table 2.1 gives an illustration of how interest cost adds in the price and adds to increase in the prices of goods and services. Panel A lists the assumed values for the numerical example. Product’s ex-factory cost per unit is the sum of direct material cost per unit, direct labour cost per unit and factory overhead cost per unit. The market price is the cost plus profit markup in the case when no leverage is used and no interest cost is paid. In the case of leverage, the interest expense is calculated as follows:
Table 2.1. Increase in price due to interest cost.
| Panel A: Assumptions | |
| Interest rate | 10% |
| Debt to asset ratio | 0.5 |
| Number of units produced | 1,000 |
| Direct material cost per unit | $40 |
| Direct labour cost per unit | $20 |
| Factory overhead cost per unit | $20 |
| Desired profit markup | 25% |
| Total assets | $100,000 |
| Panel B: Market Price with No Leverage | |
| Ex-factory cost per unit | $80 |
| Profit margin per unit | $20 |
| Initial market price | $100 |
| Panel C: Working of Interest per Unit | |
| Sales revenue | $100,000 |
| Total debt | $50,000 |
| Interest expense | $5,000 |
| Interest per unit | $5 |
| Panel D: Market Price with Leverage | |
| Ex-factory cost per unit | $80 |
| Interest per unit | $5 |
| Total cost per unit | $85 |
| Profit margin per unit | $21.3 |
| Initial market price | $106.25 |
Interest expense per unit increases with leverage, interest rate and decreases with the number of units of goods produced. Panel C computes the interest expense incurred per unit. Thus, financial institutions also prefer to serve big corporates that are able to absorb the cost of capital over a larger output. Finally, Panel D shows how the additional interest expense per unit raises the cost price as well as market price. It shows how the interest expense incurred by profitable and larger firms is eventually recouped from the pockets of consumers when they purchase the goods and services from the goods market. Furthermore, profitable
