Ethical Foundations of the Islamic Financial Industry

Abstract

This paper examines the ethical foundations of the Islamic financial industry which is strongly criticized for its similarity with conventional finance. In this paper, we argue that this criticism is based on the consequentialist reasoning. The deontological considerations are largely ignored when the focus is on aggregate returns and associated product features. We build an economic model which allows us to examine the implementation of deontological rules in the Islamic financial products along with examining their consequences. We show that the market forces may cause the returns and the attributes of Islamic financial products to converge with conventional finance even though the industry may be adhering to the Islamic deontological rules. We build a model to show that there may exist ‘Epsilon States’ where the deontological rules are followed by the Islamic finance industry, but their impact is not significant. We argue that the source of these ‘Epsilon States’ could be either moral uncertainty or costly monitoring. The presence of these ‘Epsilon States’ enable Islamic financial institutions with weak ethical commitments to create financial products where the deontological rules are followed, but their impact remains insignificant.

Appendices

Appendix A

Regulator estimates social welfare under act-based sanctions as follows:

$$ W = \mathop \int \limits_{{pf}}^{{\text{B}}} \left( {b - \sigma h} \right){\text{dG}}\left( b \right) $$

Solving the welfare function, we get the following:

$$ W = \left[ {\frac{{b^{2} }}{2} - \sigma _{g} hb} \right]_{{pf}}^{{\text{B}}} $$

$$ W = \frac{{{\text{B}}^{2} }}{2} - \frac{{pf^{2} }}{2} - \sigma _{g} hB + \sigma _{g} hpf $$

Individual’s punishment f should be such that it maximizes social welfare. Thus, we take FOC w.r.t f.

$$ \frac{{{\text{d}}W}}{{{\text{d}}f}} = - pf + \sigma _{g} h = 0 $$

$$ pf = \sigma _{g} h $$

Appendix B

Social welfare with cost of identification and monitoring of ‘Epsilon States’ and with the known probability of ‘Epsilon States’ is as follows:

$$ W = \mathop \int \limits_{{pf}}^{{\text{B}}} b - \left( {1 - \lambda } \right)\sigma h - \lambda \sigma \left( {h + \varepsilon } \right) - \alpha C~{\text{dG}}\left( b \right)~~ $$

Firstly, we solve welfare function 1 as follows:

$$ W = \left[ {\frac{{b^{2} }}{2} - \left( {1 - \lambda } \right)\sigma hb - \lambda \sigma \left( {hb + \varepsilon b} \right) - \alpha Cb} \right]_{{pf}}^{{\text{B}}} $$

$$ = \left[ {\frac{{b^{2} }}{2} - \sigma hb - \lambda \sigma \varepsilon b - \alpha Cb} \right]_{{pf}}^{{\text{B}}} $$

Opening limits now,

$$ = \frac{{\text{B}^{2} }}{2} - \frac{{\left( {pf} \right)^{2} }}{2} - \sigma h\text{B} + \sigma hpf - \lambda \sigma \varepsilon \text{B} + \lambda \sigma \varepsilon pf - \alpha C\text{B} + \alpha Cpf $$

Now, we take the derivative of the above equation w.r.t f.

$$ - p^{2} f + \sigma hp + \lambda \sigma \varepsilon p + \alpha Cp = 0 $$

$$ p^{2} f = \sigma hp + \lambda \sigma \varepsilon p + \alpha Cp $$

$$ pf = \sigma h + \lambda \sigma \varepsilon + \alpha C~ $$

Appendix C

The benefit of an individual lender when the price ceiling is ${m}_{e}^{*}=(1+c)f$ can be determined as follows:

$$ \mathop \int \limits_{{pf}}^{{m_{e}^{*} }} b{\text{dG}}\left( b \right) $$

$$ = \left[ {\frac{{b^{2} }}{2}} \right]_{{pf}}^{{s^{*} }} $$

$$ = \frac{1}{2}\left[ {(m_{e}^{*} )^{2} - (pf)^{2} } \right] $$

$$ = \frac{1}{2}\left[ {\left( {\left( {1 + c} \right)f} \right)^{2} - (pf)^{2} } \right] $$

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The benefit of an individual lender when the price ceiling is ${m}^{*}=(1+c)f+\varepsilon$ can be determined as follows:

$$ \mathop \int \limits_{{pf}}^{{m^{*} }} b{\text{dG}}\left( b \right) $$

$$ = \left[ {\frac{{b^{2} }}{2}} \right]_{{pf}}^{{m^{*} }} $$

$$ = \frac{1}{2}\left[ {(m^{*} )^{2} - (pf)^{2} } \right]~ $$

$$ = \frac{1}{2}\left[ {\left( {\left( {1 + c} \right)f~ + \varepsilon } \right)^{2} - (pf)^{2} } \right]~ $$

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