Abstract
In this paper we examine some of the economic and ethical consequences of different credit market regulations, including usury laws, complete prohibition of interest and providing ease to the borrower upon default (bankruptcy laws). The references to these credit market regulations can be found in many religious and moral philosophy texts. We first examine the effectiveness of these regulations in deterring exploitative lending by developing a model that shows lending can be regulated through either act-based or harm-based regulations. We show that act-based regulations which comprise usury laws and complete prohibition of interest deter lenders more than harm-based regulations which constitute bankruptcy laws. We then analyze that while the regulations may deter certain forms of lending behavior, they may also create certain externalities by contributing towards inequity and societal risk. We propose that a regulator’s choice of implementing credit market regulations maybe dependent on her ethical commitment towards growth and reduction of inequity. We suggest the usury laws are more ethical than bankruptcy laws; however, discouraging the use of debt contracts through prohibition of interest and encouraging the use of risk sharing contracts maybe the most ethical way to regulate the credit markets.
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Notes
These credit market regulations may have deontological origins, for example, the Islamic prohibition of interest is a deontological formulation with its roots in the religious text (Ayub 2007). A similar deontological assessment can be used to understand the importance of usury laws and providing ease to the borrower upon default (bankruptcy laws) (Benmelech and Moskowitz 2010; Lewison 1999; Persky 2007). In this paper, however, we examine some of the economic consequences of these different credit market regulations.
By examining the economic consequences of these regulations the purpose is not to pass a judgment on their intrinsic value, rather to examine their instrumental value. Sen (1991, p. 75) explains “Even activities that are intrinsically valuable may have other consequences. The intrinsic value of any activity is not an adequate reason for ignoring its instrumental role, and the existence of instrumental relevance is no denial of its intrinsic value. To get an overall assessment of the ethical standing of an activity it is necessary not only to look at its own intrinsic value (if any), but also at its instrumental role and its consequences on other things, i.e. to examine the various intrinsically valuable or dis-valuable consequences that this activity may have.”.
A regulator might be committed to complete prohibition of interest for deontological reasons but the regulator may also be interested in the consequences that such a regulation may cause. Similarly, with regard to usury laws, a regulator may have a deontological commitment to forbidding interest rates that are “too high,” but pragmatically has to look at the amount of harm caused by different interest rates to decide where the border is between “acceptable” and “too high.” The modern day manifestation of Bankruptcy laws can be explained using consequentialist reasoning.
For example, a present biased regulator may prefer to increase the current welfare of the people much more so than their future welfare (Meier and Sprenger 2010). The regulator may also have to choose between reducing inequity at the expense of bearing societal risk and growth (Rohde and Rohde 2015).
The Islamic prohibition of interest requires that the cost of capital cannot be charged on a loan or a debt contract. Loan contract from an Islamic perspective is considered a non-compensatory or charitable contract which requires that no additional payment be charged on it. Islamic law allows charging a cost of capital in a risk sharing or a trade contract.
Our results can also extend to the Islamic risk sharing modes of financing, such as Musharakah and Mudarabah, where the capital provider negotiates a profit rate with the user of funds. The returns to the investor are proportional to the profits made by the underlying venture. What differentiates this contract from a loan is that the returns of the capital provider are not predetermined but is dependent on the performance of the underlying venture. In case the venture performs well the capital gets a significantly higher return; in case of a loss it is shared in proportion to each party’s investment. The essence of the risk sharing contract is that the capital is not guaranteed. In case of loss it has to be shared between the borrower (or fund raiser) and the lender (or investor) (Askari et al. 2012). Secondly, the profit rate is negotiated. As the returns of the lender are dependent on the actual outcome of the business, the profit rate would be independent of the wealth of the individual, rather it would depend on the effectiveness of the underlying venture and the ensuing expected returns. In other words, irrespective of the quality of the collateral or the wealth of the individual, the profit rate would be negotiated based on the effectiveness of the business venture and its potential to generate more wealth. Interestingly, the borrower’s (or fund raiser’s) wealth would impact the borrowing rate (or profit sharing rate) only through the mediating influence of their performance. This makes the risk sharing contract more ethical than the debt contract.
This paper also contributes to the emerging literature on Islamic finance, which is based on the idea of prohibition of interest. Most of this literature portrays the prohibition of interest as a religions injunction, to be implemented in the personal religious space or at the financial product level (Abedifar et al. 2013). We show that it has wider economic repercussions as it can neutralize inequity and societal risk.
Simply put, act-based punishments are preventive in nature, whereas harm-based punishments are curative. Drunk driving is an act-based regulation. Irrespective of whether the person has the self control to not cause the harm, the act would be punished. The ban on short selling in some financial markets (for example in the US after the 2008 crisis) is an act-based regulation. However, manipulating the market by artificially raising the prices requires a harm-based regulation. The court has to first establish that harm to society has occurred before deciding whether the act should be punished. Garoupa and Obidzinski (2011) provide a discussion on act-based and harm-based punishments.
The type of financing which is more commonly used in the Islamic finance industry is trade-based financing. Historically these modes were used more to facilitate trade and less for the purpose of financing per se. However, the modern day Islamic finance industry is heavily dependent on the trade- and leasing-based modes of Murabaha and Ijarah. While we have not modeled trade-based modes in our paper, for it requires a deviation from the setup we have used, intuitively the model can be applied to them. The essence of any trade-based modes such as Murabaha, involves taking ownership of the asset by the bank and then selling to the customer (borrower) at a higher price. In the context of our paper we can say that the there are two aspects of rate of return that are important. Firstly, the rate that is decided ex-ante at the time of the contract. In that sense the Islamic bank’s trade-based modes are similar to the conventional loan, with the only difference being that all transactions of Islamic finance are backed by a real asset. On the other hand, conventional loans may or may not be asset based. The second part of the contract is where the person might delay the payment, and the bank may charge a higher rate for the compensation which may get compounded over time. This aspect of compounding is not present in Islamic finance, as the Islamic bank cannot price the delay but can only charge a penalty which has to go to charity. In terms of the rate at the start of the contract, trade-based contracts would also affect the rich and the poor borrowers similar to a conventional loan contract, so much so that the rich borrowers would be charged a lower rate and the poor borrowers charged a higher rate.
\(\varvec{ }F > {W}_{\text{b}}\)
The return is in addition to the cost of setup which the borrower recovers in case of success.
It’s a two period model and discounting has been ignored for simplicity.
An underlying assumption here is that the borrower would participate in the transaction if ‘r’ is such that, \(rF < W_{b} ,\) so that if the project just breaks even (i = 0), she still will be able to return the interest and principal. The borrower participates, as she ex-ante anticipates \(piF \ge W_{b}\). i.e. ex-ante \(\Delta W_{\text{b}} \ge 0\)
The project makes enough money to cover its cost of setup F.
Think of a scenario where the borrower is totally protected i.e. ϕ is approximately close to zero. In this case the lender’s participation constraint becomes \(R = \frac{{\left( {1 - p} \right)}}{p}\). If the probability of default is higher than the probability of success, the interest rate offered is greater than 1. This participation constraint of the borrower \(rF < W_{\text{b}}\) is not violated only if r < 1. For r ≥ 1 the constraint doesn’t hold as \(F > W_{\text{b}}\) by assumption.
G can be calculated using relative mean absolute difference given by: \(\begin{gathered} G = {\text{RMD}}/2 \hfill \\ {\text{RMD}} = MD/Y. \hfill \\ G = MD/2Y \hfill \\ \end{gathered}\)
For our analysis we take Y to represent expected overall wealth and MD to represent expected wealth disparity between the rich and the poor borrower. We ignore the wealth disparity between the lenders and the borrowers. The assumption is that the wealth of the lender is so high that there exists very high wealth disparity between the borrowers and the lender even before the lending. Thus, any wealth disparity that occurs as a result of lending doesn’t materially alter the overall wealth disparity in the society.
We assume, for simplicity, that the same amount (F) is lent to both borrowers. We also assume, that ϕ which represents recovery rate of the lender in case of default is 1. This simplifying assumption helps us preclude financial exclusion that results in the case of bankruptcy laws. These assumptions hold for all upcoming equations.
The total profit includes the initial investment F and the additional return from the project iF.
Before, the total interest amount rF was decided ex-ante and the borrower in case of breakeven (i = 0), had to utilize her wealth to pay the interest. In profit sharing her wealth is always protected, as only the profit sharing percentage is decided ex-ante and the absolute amount is decided ex-post depending on the project’s actual return. If the project just breaks even, the borrower still gets to keep (1- α)F in addition to her base wealth.
The borrower participates as long as \(\alpha \le 1\) i.e. \(\Delta W_{\text{b}} \ge 0\). This holds by construction as α lies between 0 and 1.
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Acknowledgements
We would like to thank the participants at the seminar hosted by the South Asian Institute at Harvard University in November 2017 for their useful comments. We would also like to thank the section editor and three anonymous referees for helping us improve the quality of our paper.
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Appendix
Appendix
Wealth-Dependent Utilities
Change in welfare as a result of interest-based lending is given by Eq. (8) which is reproduced below
If WB and Wb represent the wealth of the borrower after and before the lending transaction, respectively, and WL and Wl show the wealth of the lender after and before the lending transaction, the change is welfare is given by
For p = 1, the wealth can be written as shown below
The above expression would be negative whenever the term inside the logarithm is less than one. Since the following is always true
Then, the expression below must be true to make \(\Delta We < 0\)
Solving the above yields the following
So, whenever the reinvestment rate of the borrower is less than the interest rate charged on the loan, the welfare is negatively impacted.
The above relation would hold for the values of i ≥ 0.
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Azmat, S., Ghaffar, H. Ethical Commitments and Credit Market Regulations. J Bus Ethics 171, 421–433 (2021). https://doi.org/10.1007/s10551-019-04391-6
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DOI: https://doi.org/10.1007/s10551-019-04391-6