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Behavioural Economics – Can Islamic Banking Be Considered Rational?

Behavioural Economics – Can Islamic Banking Be Considered Rational?

IBEHAVIORAL ECONOMICS – EMOTIONS IN ECONOMIC DECISIONS Religion and Economics Can Islamic Banking be considered Rational? Emma Cornelis Corvinus University Budapest 12 May 2010 – Introduction – Classical economists ascribe complete rationality to the behavior of human beings. But do the things people do in life really make sense? According to the conventional ways of predicting human behavior and human choices, one would handle out of perfect self-interest and perfect rationality and one would in addition possess perfect information and stable preferences.

Looking at people from this so-called perspective of the Homo Economicus, many aspects of personal decision making processes remain unexplained. Specific sets of actions that are at first sight hardly explainable by rational choice theory, are those related to religion. Yet for ages the whole world has and for many people their daily lives have revolved around religion. In America, 90 percent of the adults claim to have a religion, 60 percent is member of a religious institution (e. g. a church or synagogue) and 40 percent attends religious services on a regular basis (Iannaccone, 1992).

Due to the globalization a mixture of different cultures and related religions can be found in most big cities, for instance throughout Europe. In the streets expressions of many different religions can be observed; Christians might wear a necklace with a cross, Muslim women can be recognized from their kerchiefs, Orthodox Jews wear side curls and yarmulkes. If these actors are rational as proposed by conventional economists, what is exactly the utility they receive from following a religion? In addition, many aspects of religion are a matter of belief rather than that it is proven.

A pertinent illustration of a conviction without verified information is the belief in heaven and hell after death. Why would religious, yet rational, people make a choice based on imperfect information? Edgeworth (1881) was one of the first mathematicians explaining economic models with the main principle that every agent is driven in his choices by pure self-interest. In every situation of choice, human behavior should be assumed egoistic, and consequently have the ability to choose from the options that cannot be improved more (‘the core’ of the economy). He was already at that time aware of the level of abstraction of his models.

In relation to religion, he even states that “it is far from the spirit of the philosophy of pleasure to depreciate the importance of religion”. It can be interpreted that he was meaning to say that his practices are 1 suitable for simplifying decision making, but still the real world is of course far more complex and has preferences on a higher level than pleasure (or utility). Sen (1977) points out that two important concepts should be mentioned in relation to the assumptions of individual egoism of the economic theories of Edgeworth (1881): sympathy and commitment.

The behavior following on both phenomena can contradict the theories of rationality. I will in this essay only elaborate on the concept of commitment. Commitment relates choice to an anticipated level of welfare (Sen, 1977). If you feel committed to a religion, you are expecting something in return. One expectation could be a pleasant after-life, which can be categorized as an intangible and an uncertain reward. For a lifetime one should show commitment to the philosophy of the religion in order to maybe receive the utility of it in a later stage.

In this context, it may seem irrational to act committed upon a belief like this. This is only one example, as not all religions include the belief in life after death and many more examples of commitment in the context of religious behavior could be given. According to Sen (1977), it is impossible to find a proper definition of rationality. Explaining rationality by the definition of merely acting out of self-interest is too narrowly seen in my opinion. There are many commonly known (possibly false) assumptions about religious beliefs. First of all, religion is supposed to be declining as science and technology advance.

Secondly, individuals are probably more skeptical towards faith-based claims as they are better developed and acquire better education. Thirdly, it is many times stated that members of deviant religions are indoctrinated, traumatized or influenced by other psychological abnormalities (Stark, Iannaccone and Finke, 1996). Although intuitively it is simple to point out the irrationalities in religious behavior, views on this have changed over time and some authors have on the other hand also argued for the rationality embedded in religions. – Successes of religion –

Efficient religious communities can actually be quite successful. Even if the associated religious behavior involves strange requirements and seemingly inefficient prohibitions, the success of the group as a whole can be doing very well as the value of the club good is increasing, generating positive returns to participants. Free-riding problems that are common for groups with club goods can be overcome, even though group participation is not 2 subsidized. Instead, religions typically tax alternative activities; all entrants are penalized by the fierce rules of the religion.

This can be explained as rational, as the embracement of selfsacrifice, stigma and other standards increases the group utility and consequentially the individual utility (Iannaccone, 1992). This is an interesting finding. The aspects that make the religious behavior unusual (and seemingly irrational) can exactly be the aspects that make it successful. The members of the religion thus directly benefit from their commitment to the religion, if you consider the religion a club good that has a certain value.

It can still be debated how the value should be expressed, if it is usually not expressible in financial or material returns. I will come back to this later. Evidence that religious behavior can be rationally justifiable is at hand. Barro and McCleary (2003) have studied the relationship between religion and economic growth across countries. Their results show that economic growth responds positively to religious beliefs and in special the beliefs in the existence of hell and heaven. Through a cross-country panel data has been gathered on both church attendance and religious beliefs.

Increases in church attendance tended to reduce the scores on economic growth. On the contrary, for the given levels of church attendance, increases in religious beliefs (notably beliefs in heaven, hell and afterlife) tended to increase economic growth (Barro and McCleary, 2003). Figure 1 illustrates the regression analysis of the relationships between economic growth and religious behavior. It can be interpreted that the benefits of religion for the economy depend on the values and beliefs of people, rather than the context in which they practice these beliefs.

A potential explanation for these findings could be that stronger religious convictions stimulate growth because they are motivating individual behaviors that enhance productivity. Even Edgeworth’s (1881) statements about the human behavior that maximizes the individual utility can be seen true in this context. A wider interpretation of his model should be applied in order to make this linkage. In addition, human emotions should be considered to play a significant role.

Indirectly, the beliefs of an individual will intrinsically drive personal efficiency to a level that will benefit the society as a whole, a wealth that will come back to the individual (e. g. in GDP measures). The before mentioned commitment to religion would in that case indeed be a stimulator for productivity. 3 On the other hand it is interesting to review why church attendance is negatively related to economic growth. Does the church demand resources that should be more efficiently used in another (economic) sector?

The solution in this question might lie in an analysis of a religious system of beliefs that is applied in an economic setting rather than in the services of a church, mosque or synagogue. One could say that if the beneficial ‘rules’ of a religion are applied in a business setting, the profits of both can be combined and economy and religion can be assessed conjointly. Figure 1. Economic Growth in relation to Church Attendance and Religious beliefs (Barro and McCleary, 2003) Note: Figure 1a holds constant belief in hell; Figure 1c holds constant belief in heaven. 4

Taking this information in to account in my further analysis, I am wondering what will happen if actors in a daily economic setting involve not so much the religious institution in their decision making, but moreover the values of their religion. It can be considered irrelevant as in no conventional economic model personal or religious values play a role. However, before mentioned results indicate it does have an influence in economic success. Is involving religious values into businesses, for example the banking sector, benefiting the decision making processes and therefore perfectly rational to do so?

Arguments against and in favor of this statement can be brought up. Barro and McCleary (2003) additionally mention that in particular Muslim countries score strikingly high on both the beliefs in hell and in heaven. In a regression comparing these values of the Muslim respectively to Catholic religion, the Muslim countries greatly outscore the Catholic countries (see Appendix I). Therefore I expect that this is an interesting religion to investigate more on the economic value of these beliefs. What comes to mind when putting all before mentioned findings together, is that in Western Europe Islamic banking is noticeable gaining field.

Potentially due to an increase in immigrants, or due to the recognized success of this banking methodology based on the values of the Islamic culture is growing substantially (Arriff, 1988). This banking sector allows comparisons between religious beliefs and economic success. In the next sections of this essay I will attempt to discuss the concept of Islamic banking and its (ir)rationality in more detail. In addition, an attempt to find an answer to the risen questions will be made. – Islamic Banking – Hence an example of religious behavior that is interwoven in economic behavior and financial returns, is the concept of Islamic banking.

In this context, it might be feasible to find comparisons in terms of tangible returns for the commitment to the religion. Several decades ago, the Islamic form of banking was unheard of. Today, Islamic banking is no longer a negligible phenomenon but it has been accepted as an efficient and productive way of undertaking financial intermediation (Iqbal and Molyneux, 2005). It has gained momentum and has been growing very fast. Furthermore, it is likely that Islamic banking will continue to grow and expand (Arriff, 1988). 5 Islamic banking has a doctrine of universal permissibility in business dealings.

It implies that everything is permissible unless it is clearly prohibited. The most remarkable prohibition is the acceptance or payment of interest fees (so called riba). That is why the structures are based on Profit and Loss Sharing (PLS) rather than interest rates, as in conventional banks. All the purposes of an Islamic bank are comparable to those of conventional banks, except that is practices are in accordance with the rules of Shariah, Islamic rules on transactions. Common terms in Islamic banking are profit sharing, safekeeping, joint venture, cost plus and leasing.

Iqbal and Molyneux (2005) confirm in their literature research that many studies have assessed Islamic banks in their performance on soundness, prudence, effectiveness, profitability, and more. They verify that the studies to date have shown Islamic banking by no means to be inferior to their counterparts; in fact, they appear to show even better results than conventional banks. The principle of Profit and Loss Sharing should be the key of theoretical supremacy of Islamic banks compared to conventional banks (Ibqal and Molyneux 2005, Kahn and Mirakhor, 1987). Figure 2.

Islamic banking portrayed as a winning concept (Bendib. com, 2009) 6 However, from a practical point of view, some difficulties might come with the religious rationality of the Islamic rules. After years of growth, it can be also argued that the practices of this type of banking should be a source of serious concerns. There are four main areas in which the PLS scheme has an insufficient financing structure: 1) participation in long-term low-yield projects, 2) financing the smaller players in business, 3) granting non-participating loans to running businesses and 4) financing government borrowing (Gafoor, 1995).

These forms of banking are in terms of risk and payoff not (entirely) sufficient in the Islamic banking structures. Without going into depth about these structures and their problems, it can be concluded that although Islamic banking appears to be successful in total assessments, it can also be said that it is not outperforming conventional banks in all aspects of banking. Having discussed some of the problems arising from Islamic banking structures, we can get back to the question whether holding on to religious rules and behavior should be considered rational or irrational in terms of economics.

Let me continue viewing the issue in this context. Ever since the Islamic banking structures have gained popularity, its practices have spread from east to west, from Indonesia and Malaysia all the way towards Europe and even America (Iqbal and Molyneux, 2005). From my European perspective, it has raised the question with me whether Islamic banking structures are able to hold success for the sake of its efficiencies, even if the environment and the practitioners are from another (e. g. Christian) religion.

Should political decision makers appreciate the religious foundations of this banking structure merely for its benefits in performance? Most European countries have no origins in the Islamic religion, yet people recognize the success of Islamic banking and therefore adopt its ideas. It is therefore important for European decision and policy makers to take into account this form of banking and potential issues that come along. It cannot be ignored that religious and non-religious purposes are blending together in the current implementation of Islamic banking. Migration Issues – Great differences exist when comparing Muslim and non-Muslim responses to the values of the bank. While a small proportion of Muslims have awareness of the principles of Islamic banking, non-Muslims have almost a complete lack of awareness. Muslims are more convinced that religious and profitability reasons motivate people to deposit moneys with an 7 Islamic bank (Gerrard and Cunningham, 1997). Other motivations for Muslims to support their standards of banking mainly lie in emotional, behavioral attitudes as well.

For the sake of community and continuity, they agreed more strongly that even if the bank would not make profits in a year, it would be a just and efficient system (Gerrard and Cunningham, 1997). In order to bridge the gaps that may come with the cultural differences between practitioners of Islamic banking, there exists an Institute of Islamic Banking and Insurance. The headquarters is situated in Londen, Great Brittain, a country with no Islamic foundations. The main page of the institute is starting the explanation of Islamic banking by stating that it is ‘not just for Muslims’ (see Appendix II).

It explains that the principles deal with morality and common attention to the human dimension of economy, and detaches the religion of the banking principle for the readers of this page. It wants to make the principles of this banking method accessible for anyone, anywhere. Personal values in terms of faith (or non-faith) should, according to this institute, not be an issue. Moreover, a Brittish Master program in Islamic banking is offered on the same page. What I want to point out with this information is that Islamic banking is obviously growing beyond it religious foundations to a banking method respected for its well-performance.

In my opinion it is the freedom of the market that is respected when it adopts a working concept like this. It should be approved if it is not harmful, moreover beneficial for society and economics. In situations where models turn out to be best performing in accordance to the PLS system, it is solely rational to apply these principles. Nevertheless, the issues that may arise when the values of the system will be detached from its religious background should not be underestimated. There is a thin line between the rationality (efficiency) of this banking method and the religious (value-based) reasons behind it.

As the developments in the sector are still young, it is hard to estimate what the effects will be if the banking concepts loose the underlying religious values. Will it work the same way if too many non-religious stakeholders pursue Islamic banking? If the before mentioned theories hold, concerning the beliefs in afterlife that are positively related to economic growth, the system may be in need of actors with these values in order to be successful. If commitment to these values is indeed a key-success factor, following the religion has proven to be as well personally (emotionally) as rationally contributive. Looking from the other end of the spectrum, it can be irrational for Muslims to be willing to expand like this. If the banking method is in risk of losing the power of penalizing people that do not live up to these values, it loses at the same time its common good. It is opening its doors through the banking techniques to outsiders, allowing externalities to enter the field. As we have learnt, externalities imbalance the equilibrium of the group. The common good is precisely the greatest common divider of its religion.

According to Iannaccone (1992) the cohesiveness, shared values and traditions of a group are the factors that make a collective successful. It is rational to protect those success factors from outsiders: The effects of the religion that should in theory reduce free-riding and increase commitment are eliminated (Iannaccone, 1992). – Conclusion – It can be debated whether religious choices are rational or not. Although some say that religion is based on personal values and beliefs, rather than on facts and output-maximization, the latter can certainly be found as well in religious settings.

Religious collectives have been shown to be successful because of the exclusion of practitioners that do not want to live according to the basic values. Certain behavior is penalized because of this, which diminishes the occurrence of free-riding and neglecting the values. Although joining a religious community may not seem to be motivated mostly by rationality, research points out the efficient economic contribution of religious values. For the individual living up to the values, generating economic value, it can even be reasoned to be economically rational to join the religion.

Islamic banking is an upcoming concept, spreading over the world. It has reached places and followers that do not even have Islamic origins. The logic behind the adoption of the concepts can be found in the performance of the PLS concept, in some settings a very appropriate way to grow and make profits. Using that as an argument, it can be rational to choose to adopt or join the Islamic banking concepts. The related (migration) issues can and should be researched even more in depth, but it is at least a wonderful example of how religious behavior can be intermingled with rational behavior.

However, the risk is that exactly because of this formula, the contribution of religion success will soon be lost and the rationality of religion will no longer hold. 9 – References – Arriff, M. (1988) “Islamic Banking”, Asian-Pacific Economic Literature, Vol. 2, No. 2, pp. 46-62. Barro, R. J. , McCleary, R. M. (2003), “Religion and economic growth across countries”, American Sociological Review, Vol. 68, No. 5, pp. 760-781. Bendib. com, Cartoon of January 272009. Website accessed at 11-05-2010. Link: http://www. bendib. om/newones/january/ Edgeworth, F. Y. (1881) “Mathematical Physics: An essay on the application of Mathematics to the Moral Sciences”. Gafoor, A. L. M. (1995)”Islamic Banking”, Chapter 4 in Gafoor, A. L. M. “Interest-free Commercial Banking Gerrard, P. , Cunningham, J. B. , (1997) “Islamic banking: a study in Singapore”, Bradford, Vol. 15, No. 6, pp. 204. Iannaccone, L. R. (1992) “Sacrifice and Stigma: Reducing Free-riding in Cults, Communes and other Collectives”. Iqbal, M. , Molyneux, P. (2005) “Thirty Years of Islamic Banking: History,

Performance an Prospects”, Palgrave Macmillan, London, pp. 190. Islamic-Banking. com, Institute of Islamic Banking and Insurance, homepage. Website accessed at 11-05-2010. Link: http://www. islamic-banking. com/ Khan, M. S. , Mirakhor, A. (1987), “The framework and practice of Islamic banking”, in Khan, M. S. and Mirakhor, A. (Eds), “Theoretical Studies in Islamic Banking and Finance”, The Institute for Research and Islamic Studies. 10 Sen, A. K. (1977) “Rational Fools: A critique of the Behavioral Foundations of Economic Theory” Philosophy and Public Affairs, vol. no. 4, pp. 317-344. Stark, R. , Iannaccone, L. R. , Finke R. (1996) “Religion, Science, and Rationality”, The American Economic Review, Vol. 86, No. 2. 11 – Appendices Appendix I – Table 3. Regressions for Church Attendance and Religious Beliefs for Country Surveys From Barro, R. J. , McCleary, R. M. (2003), “Religion and economic growth across countries” 12 Appendix I – Screenshot of the homepage and mission and vision of the Institute of Islamic Banking and Insurance. From http://www. islamic-banking. com/ 13