Review of Islamic Economics, Vol. 1, No. 1 (1991), pp.

49-66

RISK AVERSION, MORAL HAZARD AND FINANCIAL ISLAMIZATION POLICY

Seif I. TAG EL-DIN

Riyadh, Saudi Arabia

1. Introduction

Among the major challenges facing the advocates of Islamic economic reforms, is the issue of Islamizing the financial systems of modern Muslim societies. The fundamental Islamic norm that any form of promised return to financial capital is usury and hence prohibited, presents the Islamic system as being purely equity-based. However, the historical experience and familiarity with state-supported debt instruments, which are securely embedded in banking and financial systems, have created some misgivings in Muslim societies about the economic feasibility of the recent Islamization initiatives. Such misgivings lead to the apprehension that elimination of interest-based debt and complete reliance on risk-bearing equities, could adversely affect the supply of investible funds leading to loss of efficiency in the financial system and retardation of economic growth prospects. Although that is one of the most popular arguments raised against the replacement of debt institution by an interest-free system, it has no firm theoretical basis in the literature. The issue was never a serious concern to the Western pioneers of economic theory. In the absence of a standard analytical formulation of such a view, we shall consider an indirect implication of the mean variance portfolio choice theory, which establishes a Pareto optimal status for the Capital Market Line (CML) through utility analysis of risk-aversion. The CML stands for the institution of lending and borrowing among the risk-averse investors, at an assumed risk-free interest rate. It has been shown that the removal of the CML depresses the welfare positions of all participants, who would move towards lower equilibria positions with purely risk-bearing securities. This indirect implication is perhaps the most solid analytical exposition to be encountered in the literature, in support of the view that elimination of debt finance could bring forth efficiency 1osses.l It is worth mentioning here that the approach adopted by Naqvi (1986) in support of the same view relies on a rather ad-hoc mean-variance analysis of risk-aversion, as it makes no reference to the standard approach. Similarly, Masud (1989) took no notice of the above-mentioned theoretical implication of the mean-variance portfolio choice theory.

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He rather, proposed a counter theorem to demonstrate that risk-aversion on the supply side does not matter if there is sufficient scope for risk-diversification in the market. Alternatively, he offered a thesis of 'moral hazards' to explain the dominance of debt finance in real life. Despite the interesting change in emphasis from the commonly held views about the influence of risk-aversion, the moral hazard thesis indirectly contributes to the belief that there are powerful behavioural norms which lead to the prevalence of debt institution in actual practice. It implies that the policy of Islamization is 'costly' in the sense that if a society chooses to Islamize its financial system, it would have to bear a 'deadweight loss' in terms of necessary information costs to guard against the 'moral hazard' problem. The main objective of this paper is to critically examine the analytical basis of the proposition that removal of interest-based finance is harmful to the process of supplying investible funds. The possible harmful effects are either due to the risk-averse nature of fund suppliers, as indirectly implied by the mean-variance portfolio choice theory, or due to the 'moral hazard' problem highlighted by Masud. We will examine both of these approaches in this paper. In the next section, we start with a discussion of the Pareto optimal position for the Capital Market Line (CML) as implied by the mean-variance theory of portfolio choice. The discussion relates mainly to the utility analysis of risk-aversion with particular reference to the assumed convex curvature of the mean-variance indifference curves which provides support to the existence of the CML in the Pareto optimal position. We question the theoretical assertion due to Tobin (1958, 1965, 1974) that these indifference curves are necessarily convex when investment returns are assumed to be normally distributed. This discussion involves reference to Feldstein's (1969) criticism of Tobin, to show that he overlooked a crucial point in Tobin's proof of convexity - namely, the proof implied perfectly correlated investment returns. We highlight that the assumed convex curvature is only an analytical convenience and not a theoretical necessity. Hence, the associated indirect negative implication for the Islamic system should not be taken too far. In section three, we discuss the 'moral hazard thesis' and show its irrelevance to the modern corporate sector and the financial choice in securities markets. The discussion also includes a critical mathematical note about Masud's Theorem. The final section contains the summary and conclusions. 2. The Risk Aversion Thesis

2.1 Necessary Background The underlying theoretical framework of the standard mean-variance theory of portfolio choice relates to an informationally efficient, frictionless financial market, with a community of risk-averse investors who maximize the expected utility of their end of period wealth. The marketable securities are assumed fixed in quantity and perfectly divisible. Investors are price-takers with

S.Z. Tag El-Din: Risk Aversion. Moral Hazard and Financial Islamization Policy

homogeneous expectations, since information is assumed to be costless and available simultaneously to all investors. Finally, returns on securities have a multivariate normal distribution, and a risk-free security exists such that investors may borrow or lend unlimited amounts at the risk-free rate. An elaborate exposition of the theory is available in any text book on portfolio analysis and is summarized in Figure 1below. Fama and Miller (1972) provide a more formal verification of the equilibrium position, shown in Figure 1.
Figure (1) Equilibrium in Financial Capital Market

The risk free rate

risk ( a )

The basic model consists of three main building blocks: (1) An investment opportunity set constructed from knowledge of expected returns, and variance1 covariance parameters of the marketable securities; (2) A set of mean-variance indifference curves, to characterize the community of risk-averse investors; and (3) A Capital Market Line (CML), which defines all possible portfolios consisting of the risk-free security and the market portfolio of risky securities (p). Equilibrium is defined as the point of tangency between CML and the efficiency frontier (EF) of the investment opportunity set. As clearly shown in Figure 1, every investor maximizes expected utility by getting involved in lending and borrowing at the risk-free rate. Particularly, the portfolio holdings of the more risk-averse (i.e. those with relatively steep indifference curves) are allocated proportionately, between the risk-free security and the risky portfolio (p).

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Consequently, if the debt institution is abolished, the welfare positions of investors worsen. This is shown in Figure 2. Each investor is now maximizing expected utility at a lower tangential point with the efficiency frontier (EF), involving only risky securities.

Figure 12)

return

Welfare losses due to Removal o f CML

risk o

This brief description reveals how Pareto optimality in the financial market is lost by the abolition of debt institution (i.e. the CML). In the current debate about the feasibility of the financial Islamization policy, this theoretical implication has led some people to argue that the abolition of debt institution brings forth efficiency losses in the financial market. As it appears, the model describes the act of lending and borrowing at interest as a utility enhancing economic activity by exploiting convex indifference curves. The convexity property implies increasing risk-aversion for all participants in the financial market, but this is a questionable property as we shall shortly explain.
2.2 A Critical Analysis

Despite its broad range of critics in the current literature, the mean-variance theory of portfolio choice gained popularity in the applied field of security

S. I. Tag El-Din: Risk Aversion, Moral Hazard and Financial Islamization Policy

analysis, mainly due to the computational convenience of this model. Faulhaber and Baumol (1988) consider the portfolio selection model among the major innovations in economics. On the other hand, various critics (e.g. Samuelson (1967); Borch (1974); Feldstein (1969); Agnew (1971); and Roll (1977)) have criticized several aspects of the theory. The criticisms of Feldstein are particularly relevant for our analysis as they relate to the curvature of mean-variance indifference curves. Feldstein questioned the convex curve specification utilized by Tobin's theory of liquidity preference as behaviour towards uncertainty (Tobin: 1958, 1965). In his critical discussion of Tobin's theory, Feldstein attained two significant results: First, it is not true that the mean variance indifference curves are necessarily convex whenever investment returns are assumed to follow any two-parameter probability distribution. Second, the portfolios formed by combining more than one security cannot in general be ranked in terms of mean-variance indifference curves. In other words, an analysis through m and a is not strictly possible 'unless utility functions are assumed quadratic or probability distributions are severely restricted' (Feldstein: 1969, p. 11). The first finding emerged from a critical analysis of Tobin's assertion (Tobin: 1958, 1965) that whenever investment returns follow a two-parameter probability model, m-a indifference curves are always convex from below. While rejecting the convexity proposition in general, Feldstein accepted Tobin's assertion in case of normally distributed returns, thus remarking, 'Although Tobin's proof is correct for normal distribution, for a number of economically interesting distributions the indifference curves are not convex' (Feldstein: 1969, p.5). Tobin (1974), while commenting on the criticisms of Feldstein and Borch, re-asserted the downward convexity property in case of normally distributed returns, and emphasized the analytical convenience of the normal distribution in the theory of portfolio analysis. The downward convexity property of the m-a indifference curves has been derived by Tobin as a consequence of expected utility maximization when investment returns are normally distributed. This theoretical assertion is by now, often reported as an accepted text book result.2 In this paper we question the validity of this assertion. The issue seems to have been by-passed due to the more recent developments and theoretical refinements of portfolio theory. Because of many implications of this assertion, the issue deserves another critical review. We will attempt to show that even when investment returns are assumed to be normally distributed, the m-a indifference curves may take a number of possible shapes and not necessarily the convex one. The convex specification is commonly accepted only as an analytical convenience. It is shown that Tobin's proof of convexity implies pairwise perfectly correlated investment returns in the mean-variance space. Surprisingly this obvious mathematical point went unnoticed by earlier critics.

Review of Islamic Economics, Vol. I , No. 1

2.3 Indifference Curves and Correlated Returns

The main point noted by Feldstein in his critical discussion of Tobin's theory of liquidity preference was that: Not every two-parameter probability model can be cast into the standard normal form (i.e. z = (x-m)/o), as implied by Tobin's proof for the convexity assertion about m-o indifference curves. This clearly explains Feldstein's acceptance of the proof in case of normally distributed investment returns. However, the crucial point to note is that even in the normal distribution case, the validity of the proof is restricted to the case where investment returns are pairwise perfectly correlated. This can be seen from a careful examination of Tobin's proof showing that risk avertors (i.e. those with declining marginal utility of money income) have convex m-o indifference curves (Tobin: 1958, pp. 75-6). The proof involves the following steps, as explained by Feldstein (1969, p.6). (i) Expected utility is defined in terms of normal distribution, and the utility function U(x), as

roo

U (m+o z) 0 (z) dz

S,

where 0(z) is the standard normal density, and the cardinal utility function for money income U(x) is assumed to obey the Nueman-Morgenstern consistency axioms of rational choice under uncertainty. (ii) Declining marginal utility (i.e. U,, = < o) implies that for every 2.

Thus, representing risk aversion. (iii) Let the two points (m,o) and (m1,a')lie on the same indifference curve for an investor, i.e. (iv) Then, from (i),(ii) and (iii), it follows that: u{(m+-mf)/2, (o+o')/2) Z ) > u(m,o) =u(ml,ol) which implies that the indifference curve is convex from below since the midpoint {(m+m1)/2, (o+af)/2) of the straight line connecting the two points { ( m , ~ ) (m',o) lies above the indifference curve which connects these three , points. See Figure 3.

S.Z. Tag El-Din: Risk Aversion, Moral Hazard and Financial Islamization Policy

Figure (3) olm'.o") return

> ulm.o)

= u(m',o')

2.3.1 Indeterminacy of the Convexity Assertion

It is immediately noticeable from step (ii) above that the three points { ( m , ~ ) (m' + o t ) ; ((m+m1)/2, (o+o1)/2)), correspond to three pair; wise perfectly correlated return variables, (X,Xr and Xu), defined in terms of the same standard normal variable Z , as:

That is a(X, X') = o(X, X") = o(X1, X ) = 1 (9) from the definition of correlation coefficient, e.g. o(Xt, X) = cov (XI, X)/oto, where cov (X1,X)= o'o Otherwise, if the three points in the (m,o) space stand for independent or non-perfectly correlated return variables, it will not be possible to maintain step (ii) which is crucial for the proof. In this case the three return variables turn out to be:

Review of Islamic Economics, Vol. I, No. 1

Where mu= (m+mf)/2; orL(o+a')/2; and the standard normal variates Z,Z1, Z" are pairwise independent or non-perfectly correlated. The determinate relation of step (ii), which still holds if Z" = (Z+Z1)/2will now be replaced with the indeterminate relation of the form:

>
U(mlr, a" Z") -(1/2) U(m+a Z)

<

depending on the value of Z" relative to Z and Z' since in this case it is true that Z" 8 (Z + Zr)/2. This point is shown in Figures 4, a & b. Accordingly,
Figure 141 la) The Determinate Relation:

N.0: Here Z is fixed X'=m"+o"Z; X ' = r n ' + o ' Z ; X = r n + o z (X". X ' , X are pairwise perfectly correlated)

the final step of the proof (step (iv)) will also be replaced with the indeterminate relation:

56

S.Z. Tag El-Din: Risk Aversion, Moral Hazard and Financial Islamization Policy

It, thus, appears that declining marginal utility as defined in terms of the deterministic utility function U(X) of money income, is insufficient to imply

Figure (4) lbl The chance that: U(m"+o'Z")<'hU(m+oZl+'hU(m'+o'Z')

The Indeterminate Relation

N.6: 2C (Z+Z'I12 where: = ","+o"Z" ; X'=,"',,,' Z' ; X=m.&',Z Inon-perfectly correlatedl

downwards convex m-u indifference curves. In fact it is possible to construct a family of concave risk indexed expected utility functions, i.e. {u(m,a); a 3 o ) , such that the ordinary U(X) becomes U(X) = u(m,o). On this basis we may perceive the insufficiency of declining marginal utility of expected returns (i.e. u,, <o) as a condition to yield convex m-a indifference curves. , This is demonstrated in Figures 5, a & b, where the property (u , < o) is satisfied by every member of the risk indexed family of expected utility

Review of Islamic Economics, Vol. I , No. 1

Figure ( 5 ) (a) The Case: u(m";o") > u(m;o) = u(m'; 0'1 = E' Expected utility

rn

rn"

m'

relurn

NB: A Family of concave risk-indexed expected utility lunclions: (u(rn;o); o<o<o"co'<o') (Here Uoo<'o]

functions. The general pattern of the family reflects the first order condition: u <O but it is generally true that:

>
u(mU,a") - E *

<
where E*=u(m",o*)=u(m+o)=u(m'+u') It can be shown that the implied m-a indifference curves may take different possible shapes (linear, convex, concave . . . etc.), depending on suitable a priori restrictions, about uoo to be imposed on the family of risk-indexed expected utility functions, (i.e. whether u o o 0). Adherence to the specific downwards convex curvature for the indifference curves may be justified only on pragmatic grounds, i.e. to yield a simple and empirically convenient model of portfolio selection. Such pragmatism of the model is well recognized. However, it should be noted that there are many scholars who are sceptical about the very appeal of normal distributions, or

S.Z. Tag El-Din: Risk Aversion, Moral Hazard and Financial Islamization Policy

Figure (5)
(b) The Case: ulrn".~") E' c

Expected utility

rn falls below uirn;oa) (Here u >o) 00

m"

m'

return

N.0: The risk-indexed expected utility curve u1rn;o")

of quadratic utility functions. Agnew (1971) discussed a special theoretical assertion regarding the appeal of normal distributions by portfolio choice theory, and gave many counter examples. Borch (1974) was sceptical about the very existence of m-a indifference curves.

3. The Moral Hazard Thesis

3.1 Necessary Background

Masud (1989) has shown that under certain reasonable assumptions, Islamic profit sharing contract dominates fixed return debt contract. He then goes on to explore that if this is so then why in real life debt contract is more popular. He offers a thesis of moral hazards to justify dominance of debt finance in real life. The 'moral hazard problem' in his model arises from the ability of real investors to exploit a relative informational advantage over suppliers of investible funds. This advantage arises from the inability of fund suppliers to directly monitor and observe the true investment return. The tendency of real investors to under-report the true return is taken as the main reason that makes the Islamic profit sharing contract less attractive to suppliers of funds compared to the fixed return debt contract. Such a situation is

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attributed to the absence of 'informational symmetry' in the financial markets. Informational symmetry will hold when both partners (real investor and supplier of funds) are equally informed about the actually realized returns. Fulfilment of this condition in actual practice is costly. On this ground, Masud concludes that the policy of Islamizing the financial sector involves a 'deadweight loss' in terms of scarce economic resources, that would be used up in the efforts to maintain informational symmetry.
3.2 Critical Appraisal

Though proving superiority of Islamic modes of financing on theoretical grounds, Masud has pointed out some problems in their practice which may contribute to the viewpoint that the abolition of interest-based debt finance may adversely affect suppliers of investible funds. In place of the risk-aversion factor, implied by the standard mean-variance theory, the moral hazard theory emphasizes suppliers' distrust in the disclosure of information about the true returns realized by real investors (i.e. the demanders for funds). As regards the effect of risk-aversion on the part of suppliers, it has been completely assumed away in Masud's theorem through an appeal to the law of large numbers. On this basis Masud's theorem establishes the Islamic profit sharing contract as the Pareto optimal choice in relation to the rival fixed return debt contract, when 'informational symmetry' obtains. This theorem clearly contradicts the implication of mean-variance portfolio theory which establishes Pareto optimality for debt finance (in terms of the CML) within an environment of informational efficiency. (See section 2.1.) We shall shortly return to this point, but first we will discuss the relevance of the moral hazard thesis to the modern corporate sector.
3.2.1 Moral Hazard and Corporate Finance

It is easy to see that the moral hazard problem relates mainly to situations which are dominated by non-incorporated small-scale firms. The theory has little relevance to the modern large-scale corporate sector which accounts for the bulk of investment activity. The owner of a small one-man firm is able to capitalize on relative informational advantage by under-reporting the true return of investment to his financier. But this cannot be contemplated when the firm is a legal person, as it will simply mean that the company's board of directors may under-report the true returns to the shareholders. When the real investor is a legal rather than a natural person, the reporting of investment returns becomes exposed to various administrative checks and controls and normally no single individual may have a relative informational advantage in that reporting process. In modern financial investment theory moral hazards are mainly restricted to securities markets where illegal practices may bias the expectations about security prices (e.g. Frenzies, 1966). The main

S.Z. Tag El-Din: Risk Aversion, Moral Hazard and Financial Islamization Policy
limitation of Masud's moral hazard thesis is reflected in its failure to explain financial choice in securities markets. That is, how would a potential investor make a choice between a risk-bearing equity and an interest-based bond?
3.2.2. Islamic Banks and the Moral Hazard Problem

The moral hazard thesis is however useful in explaining the present financial activities of Islamic banks, namely the dominance of the mark-up system.3 Islamic banks are understood to be financial institutions based on the Islamic principle of profit sharing. However, in practice, while profit sharing is being widely used in the relationship between the bank and the basic suppliers of funds (depositors), in the relationship between the bank and investment agents (i.e. demanders for funds), it is not very popular. There, the mark-up system is often preferred. It is essentially the moral hazard problem which explains the general unwillingness of the management of Islamic banks to supply individual investment clients with funds on a profit sharing basis. However, the moral hazard problem is irrelevant when the investment agent is a legal entity issuing equities to attract investible funds. Islamic banks may buy such corporate equities. For the same reason the moral hazard problem did not prevent Islamic banks from attracting voluminous funds from the public on a purely profit-sharing basis.
3.2.3. The Financier's Attitude Towards Risk

We shall conclude this section with a mathematical note about Masud's theorem which establishes profit-sharing as the Pareto optimal choice relative to debt finance, under certain assumptions involving informational symmetry. It is noticeable that the assumed theoretical environment fairly compares to the frictionless, informationally efficient environment upon which the standard mean-variance theory of portfolio choice is based. The essential difference is that, whereas the standard theory relates to a secondary financial market, Masud's theory relates to a primary market involving the initial interaction between a supplier of investible funds and real investment agents. In Masud's 'primary market' model it is assumed that a single supplier of investible funds may choose from two possible options: (a) The Islamic Variable Return Scheme (VRS), and (b) The interest-based Fixed Return Schemes (FRS). There is an unlimited scope for diversification of risk, given the assumption of a large number of investors and the assumption of identically independently distributed investment returns (i.i.d. returns). The model specifies a fixed profit-sharing ratio (h) for the VRS pay-off and a risk-bearing interest rate for .the FRS pay-off, such that the associated expected pay-offs under the two schemes are equalized. If (Pv) stands for the VRS pay-off and (Pf) for the FRS pay-off, this implies:

Review of Islamic Economics, Vol. 1, No. 1

Where P,
=

n n Xi and Pf = C Yi i= 1 i= 1

and the random pay-off variables [Xi , Yi] are defined as: Xi=i hR i.e. The share of the supplier of funds in the total return Ri realized by the l t h investor (i = 1, 2 ,.... ., n) Yi = min (D, Ri) i.e. the alternative pay-off through the FRS. Here the lender is paid either a fixed pay-off (D), or the total return (R,), whichever is smaller. Then it is shown that every real investor would strictly prefer VRS to FRS. As regards the supplier of investible funds, it is shown .that in the limit, where risk diversification is taken far enough, he will be indifferent between the two options. In a nutshell, this provides the basis for Masud's theorem that:

'Corresponding to each FRS, there is a VRS which improves everyone's welfare'. The crucial premise on which the theorem is based relates to the supply side in terms of an appeal to the law of large numbers (LLN) implying that as the fixed investible fund becomes diversifiable over larger and larger numbers of real investors:

The utility function U(P) is assumed bounded and continuous, to allow for the risk aversion of the supplier of investible funds. Given the equal expectations restriction E(Pf) = E(Pv), it follows that in the limit:

Thus, the supplier's negative attitude towards risk has been completely removed through the process of risk diversification and the two options (VRS and FRS) become equally attractive to the supplier of investible funds in terms of utility. On this ground the role of risk-aversion was ignored and greater emphasis was placed on the moral hazard problem. However, a close scrutiny of this approach reveals a serious flaw. It implies a supplier of funds who is already risk neutral! This can be proved as follows:

S.Z. Tag El-Din: Risk Aversion, Moral Hazard and Financial Islamization Policy

First: The limiting statement about the ultimate convergence of U(P3 and U(P,), respectively to U(E(P,)) and U (E (P,)) incidentally, underlies the theory of weakly consistent estimators.4 That is, if the true expected values E(Pf), E(Pf) are unknown, and hence the true utilities U(E(Pf)), U(E(P,)) are also unknown, then they can be estimated consistently by the calculation of P,, Pf . It is the estimation risk, and not the economic financial risk, associated with the weekly consistent utility estimators U(Pf), U(P,), that will gradually converge to zero as the scope of diversification increases indefinitely. Hence, if the irrelevant theory of estimation is ignored, then the limiting statement merely implies that the ultimate choice decision (between VRS and FRS) is based on the true and known values of the expected returns, E(Pv), E(Pf), no matter how large or small is the extent of risk diversification (i.e. whether n = l or n=1000). And given the equal expectations restriction, he must be risk-neutral. Second: In terms of the expected utility approach, the expected utilities U(E(P)) for either FRS or VRS underlie a linear utility function of the form:

which characterizes risk neutrality. This follows directly from the fact that E is a linear operator, and unless U(P) is linear to imply: E (U(P)) = a E (P)

+ b = U (E(P))

(22)

it is, otherwise, true that E (U(P)) $U (E(P)). Thus, the supplier of investible funds does not possess the assumed bounded utility function of risk avertors. For if U(P) were bounded, the expected utility function EU(P) would involve other distributional parameters of the payoff variable P in addition to E(P). In the case where P is assumed to be normally distributed, as in the standard portfolio theory, expected utility is a twoparameter function as:

Hence, Masud's theorem relates to the less interesting case where the financier is risk-neutral. Risk-aversion has been unjustifiably assumed away, mainly to focus on the moral hazard problem.
4.

Summary and Conclusions

In this paper we have made a critical analysis of the general theoretical proposition that the abolition of interest-based debt finance is harmful to the

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economic development. Although it is one of the common arguments made against the policy of Islamizing financial systems in the modern Muslim societies, it does not seem to stand on a firm analytical basis. There are two main analytical formulations to be encountered in the literature, cited in support of the above proposition. The first is an indirect implication from the standard mean-variance theory of portfolio choice, showing through the utility analysis of risk-aversion, that the abolition of debt depresses the welfare positions of all participants in the financial market. We refer in the discussion to this implication by 'the risk-aversion thesis'. The second is the 'moral hazard thesis' proposed by Masud (1988) to explain the dominance of debt finance in practical life, suggesting moral hazard as an objective constraint in the way of financial Islamization policy. Both of these arguments have been shown to be wrong or exaggerated. (a) As regards the risk-aversion thesis, we have demonstrated its reliance on the convexity property of the mean variance family of indifference curves which are used to characterize the community of risk-averse financial investors. Tobin's assertion that given the assumption of normally distributed investment returns, these curves are necessarily convex, has been questioned. We have proved that this assertion involves the highly restrictive case where investment returns are perfectly (positively) correlated. If investment returns are pairwise independent or non-perfectly correlated, the indifference curves may take various shapes and not only the convex one. This finding highlights the fact that convex shapes are chosen on purely pragmatic grounds to yield a computationally convenient portfolio selection model. Hence the associated indirect negative implication for the Islamization policy has no theoretical basis. (b) It has also been shown that the moral hazard thesis lacks analytical relevance to the modern corporate sector. This serious limitation is reflected in the inability of the moral hazard problem to explain financial choice between equities and interest-bearing bonds. The thesis is useful, however, in explaining the general unwillingness of Islamic banks to supply individual agents with investible funds on a profit-sharing basis. But the moral hazard problem has not prevented Islamic banks from attracting voluminous profit-sharing funds from the public on a profit-sharing basis. It is also not a hindrance in the way of Islamic banks' supplying the corporate sector with funds on a profit-sharing basis, through purchases of equities. We have also drawn attention to an analytical flaw in Masud's theorem which demonstrates, in the presence of risk-aversion and absence of moral hazards, that profit-sharing is Pareto optimal compared to debt finance. The theorem implies that risk-aversion does not matter if sufficieqt scope for risk diversification exists. However, it relies on an appeal to the law of large numbers which conceals the fact that the assumed supplier of investible funds possesses a linear utility function. The theorem, thus, relates to the less interesting case of risk neutral financiers.

S.Z. Tag El-Din: Risk Aversion, Moral Hazard and Financial Islamization Policy

(c) The previous critical discussion shows that the current misgivings about the economic feasibility of the financial Islamization policy, lack a firm analytical basis. This is not to say that we can assume away the practical difficulties and worries associated with re-structuring of the economy to operate it on a profit-sharing basis. Such problems are there; but they are mainly of a political or administrative nature and are not attributable to the economics of profit-sharing. Most of these are results of past political decisions which produced the present financial structure and its banking conventions in Muslim societies. (d) It is questionable whether the bare principles of economics may be sufficient to advocate debt finance in terms of any welfare-promoting economic norm. What really matters is empirical relevance to the given socio-economic context and its value system. It was essentially empirical relevance to the Western socio-economic structure, that initially inspired the pioneers of neo-classical (positive) economics. Positive economics is indeed a structurally conservative science in the sense that it takes for granted the observable practices and attitudes of the members of a society, and the way they choose to organize their economic activities. Some Western economists have, nonetheless, gone beyond the boundaries of the structurally conservative science. For example Weitzman (1984) attributed the chronic problem of stagflation to the fixed wage-rate system, which he considered a critical 'structural flaw' in the developed market economies. Accordingly he recommended re-structuring of the developed economies to function as share systems. It is rather unfortunate that the value-loaded debt system despite its numerous problems, continues to be cherished in the main economic circles. It is high time that the merits of a sharing-based financial system are given more serious consideration in practical circles.

Notes
1. We have deliberately ignored similar implications based on perfect foresight models (e.g. Fisher's Theory of interest), for the obvious reason that under the perfect information assumption where profits are perfectly predictable, the current controversies regarding the financial Islamization policy will not even arise. The fact that the interest-based financial system is, nonetheless, retained in the perfect foresight neo-classical models of capital theory, is explainable by the property of structural conservatism of positive economics. That is, because profit-sharing is empirically irrelevant to the real life practice in the developed societies, it cannot be derived theoretically, only as a logical consequence of the abstract environment. This methodological property of positive economics does not seem properly appreciated in Muslim societies by economists who believe that standard economics is a universal value free discipline. More precisely, it is indeed neutral embodiment of the social value system that prevails in the modern Western societies.
2.

For example, see R. A. Haugen, (1986).

3. The mark-up method of finance is called Murabahah in 1slamicjurisprudence.LJnderthis scheme the financier buys the goods required by a customer and re-sells them at a pre-agreed profit margin. The customer agrees to pay the price in instalments to the financier.

4. For example, see Rao (1973) pp. 344-5.

Review of Islamic Economics, Vol. 1, No. I References

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