Islamic finance principles to restore policy effectiveness

| Saturday, July 25, 2009

The problem

Further expansionary monetary policy has become rather ineffective in the overdeveloped world because banks are capital-constrained rather than liquidity-constrained and because liquidity spreads in financial markets that bypass the banks have shrunk remarkably. Remaining spreads between sovereign debt instruments and assorted private securities of similar maturities can now be rationalised quite easily as reflecting just differential default risk. Until the banks get significantly more capital on their balance sheets, quantitative easing, credit easing and enhanced credit support are examples of pushing on a string.

The banks will take the liquidity offered and redeposit the bulk of it with the central bank again rather than lending it to the private sector or purchasing more risk financial instruments. Low official policy rates (and the expectation of the official policy rate being kept at a low level for a further significant period of time) will help recapitalise the banks. So will the quasi-fiscal subsidies most central banks have been channelling into the banking system through the favourable terms offered by the central banks to the private banks in their transactions, facilities etc., but such gradual recapitalisation through wide margins on low volumes of lending is slow and could lead to a re-run of Japan’s lost decade for much of the G7.

Further expansionary fiscal policy is likely to be ineffective in most of the G7 countries (possibly excepting Germany and Canada). This is, first, because households are short of capital and overly indebted and, second, because any further increase in short-term fiscal deficits is likely to undermine confidence in the sustainability of the fiscal-financial-monetary programme of the state.

Excessive indebtedness of households can, especially when consumer psychology swings from optimism and recklessness to pessimism, caution and prudence, give rise to a strong precautionary saving motive. Household income or wealth windfalls will tend to be saved rather than spent on consumption. Consumption or saving behaviour under such conditions is well-characterised by a simple target wealth model, with households making up the gap between target and actual financial wealth as quickly as possible, subject to a psychologically/socially determined ’subsistence’ level of consumption spending. Under such conditions, tax cuts will be mostly saved and the public spending multiplier will be disappointingly low.

When markets begin to fear that the politics of medium-term and longer-term fiscal tightening - tax increases and public spending cuts - do not look credible, the realisation will dawn, even in the most myopic of our short-sighted financial markets, that unsustainable public debt expansions will either lead to sovereign default or will be monetised and lead to inflation in the medium to long term (starting, say, 4 or 5 years from now). The state is short of capital and overly indebted. An expected inflation premium will boost long-term nominal interest rates. An inflation risk premium may raise long-term nominal and real rates. If sovereign default cannot be ruled out (and where can it truly be ruled out with complete certainty), credit risk premia will boost long-term nominal and real interest rates as well. Financial crowding out of interest-sensitive private spending will result.

I have left the non-financial corporate sector out of this litany of capital-deficient overly indebted sectors. I still believe that the non-financial corporate sector in North America and Europe by and large started the crisis-cum-recession season in reasonably good shape. If, however, Andrew Smithers is right, and even in August 2007 the balance sheets of many non-financial corporates in the north-Atlantic region were wonky, my argument of a general capital shortage and excessive indebtedness (and therefore of excessive leverage) would apply to every sector in the domestic economy of the north-Atlantic region.

A possible solution: the application of Islamic finance principles through the equitization of private and public debt.

If too much debt and too little capital are (part of) the problem, then the conversion of debt into equity is (part of) the solution.

Capital structure or financial structure is irrelevant in a complete markets model. Indeed, the standard interpretation of the complete markets model has no financial instruments at all. There is a single grand market at the beginning of time in which contingent spot and forward contracts are traded for all real goods and services. The rest of history is simply the monitoring of the states of the world that materialise and the delivery in each period, location and state of the world, of the real goods and services contracted for at the beginning of time.

This, of course, is crazy stuff, but a lot of economics, and even a lot of macroeconomics got stuck in that time-warp. Even without complete markets, there are other, slightly less restrictive economic models (although still quite dangerous as stylised representations of the real world) in which capital structure/financial structure (debt, equity, retentions, dividend policy etc) don’t matter for the performance of the economy. In such Modigliani-Miller worlds, individuals or households can always undo, by changing the composition of the household financial portfolio, anything a corporation may try to do.

For instance, if a company decided to decrease its leverage by issuing more equity and using it to buy back debt, its shareholders can neutralise this action by increasing home-made leverage, that is, by borrowing more (to buy the company’s equity). In an extreme version of the Modigliani-Miller world government financial policy (or at least the choice of debt vs. lump-sum taxes) is irrelevant as well as corporate financial policy. If the government cuts my (lump-sum) taxes and borrows instead, thus redistributing resources from my heirs (who will pay higher taxes to pay for the increased public debt) to me, I simply turn around, save my tax cut and leave the tax cut in its entirety as a larger bequest to my heirs. They use the increased bequest to pay their higher taxes.

Again, we don’t live in a Modigliani-Miller world. Limited liability applies to firms, but not to households. Default and bankruptcy are costly processes that consume real resources. Indeed, all external or third-party contract enforcement is costly. Most intertemporal trade (and all of finance) involves time-inconsistent actions by at least one of the parties and relies on external or third-party enforcement. Self-enforcing contracts, relying on repeated interactions, reputation and private punishments or rewards are few and far between. Taxes are distortionary and don’t affect households and firms in the same way. Most household wealth (the present value of current and future labour income) is illiquid, non-tradable and cannot be collateralised - courtesy of the abolition of slavery and indentured labour. Private information and complex principal-agent problems (between shareholders, managers and workers) further undermine the Modigliani-Miller view of the world. Financial structure matters.

Debt is a fixed commitment on the part of the borrower. Default on debt is a costly process which can be traumatic for those involved. Debt has its uses. In a world of incomplete markets and incomplete contracts and with hard budget constraints (including credible enforcement of debt contracts), debt can have a disciplining influence on managers (as agents for the shareholders in one of the corporate principal-agent relationships). When there are hard budget constraints, debt can act as a bonding mechanism because the debtor exerts additional effort to avoid the personal costs of financial distress. Of course, this only works if the budget constraint is hard. With soft budget constraints - the situation of banks that are bailed out by the tax payer when their debt threatens to go into default - debt has no incentive-improving and effort-enhancing impact on the agent.

When the economy is in sufficiently deep dodo, debt can become paralysing: its stops socially useful expenditures and risk taking. We are likely to be in such a situation now, with much capital destroyed and with public debt about to be boosted to sustainability-threatening levels by the deficits caused by collapsing economic activity, normal countercyclical spending increases and extraordinary public sector financial rescue efforts.

It is therefore time to turn water into wine or, failing that, to turn debt into equity; in some cases both the existing stocks and new flows should be equitized, in other cases only new flows.

The equitization of bank debt

I have on many occasions advocated the recapitalisation of banks through mandatory debt-to-equity conversions. Ideally this would occur through an expedited process of ‘insolvency lite’, through the special resolution mechanisms (SRR) that exist (or where they don’t exist ought to be created in a hurry) for banks and other systemically important institutions. Simply, the unsecured creditors of banks and similar institutions, starting with those holding subordinated debt and working up the seniority ladder until enough capital has been created, receive a letter in the mail saying: “Congratulations, you are now a shareholder. There will be no dividends or share repurchases for a while.”

This is fair (certainly much fairer than making the tax payer cough up) and it is efficient, properly aligning incentives for future risk taking. The unsecured creditors have had the benefit for many years of gratis default insurance. It is time they engaged in some true risk and profit sharing.

The equitization of mortage debt.

Household mortgage debt could be turned into an equity claim. Many proposals of this kind have been floated in the US for quite a while now. For a new equity mortgage, the bank would start off as the owner of the property that secures the mortgage. The contract could take the following form. With a 20-year mortgage, say, the ‘borrower/tenant’ would pay the bank a rental to live in the property, plus a periodic payment transferring part of the equity in the property to the tenant, say 5 percent of the purchase price each year.

The intial value of the equity (the purchase price) is the present discounted value value of the rentals expected not just over the 20 years of the mortgage contract, but over the entire economic life of the property. The actual rental payments would be determined by some index of local market conditions. Each period the bank would only receive a share of the total rental income from the property equal to its remaining equity share. As long as the tenant meets the terms of the contract, she cannot be forced to vacate the property. The bank could sell its share of the property (and the right to collect the rents for the remainder of the mortgage). It would have a stake in the upside (and the downside) of the property market.

A mortgage contract of this nature (suitably modified to allow for past interest and amortisation) could be offered to existing mortgage holders who are in default on their mortgages as an alternative to repossession. It could significantly reduce the socially wasteful repossession costs, which have been estimated for the US at between $50,000 and $80,000 per property repossessed. It could also be offered as an alternative to regular mortgages for new home borrowers.

The equitization of public debt

How can we turn public debt into something more akin to equity? One way would be to replace regular fixed or variable interest rate bonds by a security that would have the growth rate of nominal GDP (plus or minus some fixed number) as its interest rate. With $1 million worth of 10-year debt, for instance, there would be an amortisation of $100,000 each year, unless the growth rate of GDP that year were negative. With 5 percent nominal GDP growth in the first year, interest that year would be $50,000. With minus 2 percent GDP growth in year 1, interest payments would be minus 10,000, which could be paid as a reduction in principal repayments that year to $90,000.

This way, with government revenues and deficits so closely coupled to GDP (as a measure of the effective tax base), weak growth would reduce the expansion of the public debt through the intrinsic debt dynamics that comes out of the product of the interest rate and the outstanding stock of debt.

Argentina issued GDP growth warrants of this kind following its latest debt default in 2002. Of course, this could only work if the statistical office in the country were independent of the government and did not fiddle the GDP growth data to minimize the government’s interest burden. A way to handle the long-lasting stream of GDP revisions would also have to be found, but such technical problems can surely be overcome. Even without fiddling the data, the fact that the growth rate of nominal GDP is, within limits, controllable by the government, could create worries about adverse incentive effects on the borrowing government. It is, however, hard to imagine a government that would slow down the growth rate of its economy just to reduce the interest rate on its debt.

This form of risk-sharing between the borrowing government and the investor would seem to be of interest not just in crisis situations but more generally. New government borrowing could take this form even for governments of undoubted fiscal rectitude. Governments threatened with the prospect of having to default on their debt because of unexpected weakness of GDP could try to restructure existing debt by offering to swap it, at a discount, for GDP growth warrants of the kind described earlier.

Conclusion

Debt, characterised by fixed financial commitments, can be a poor financing choice in a risky, uncertain world where the private and social costs of default are high. Many distortions, often created by policy makers, have contributed to the excessive use of debt in the private sector. There is the nonsense that (nominal!) interest is a deductible cost in the calculation of taxable corporate profits in many countries, but that dividends or retained earnings are not deductible. The deductibility of residential mortgage interest in the personal income tax system of many countries (although not in the UK) is another obvious distortion. While it is true that, in the presence of asymmetric information, certain agency problems can be mitigated if companies issue debt (as long as there are hard budget constraints), the highly leveraged state of many households, financial institutions and governments today would appear to be undesirable, preventable and remediable.

What we need is the application of Islamic finance principles, in particular a strong preference for profit-, loss- and risk-sharing arrangements and a rejection of ‘riba’ or interest-bearing debt instruments. I am not talking here about the sham sharia-compliant instruments that flooded the market in the decade before the crisis; these were window-dressing pseudo-Islamic financial instruments that were mathematically equivalent to conventional debt and mortgage contracts, but met the letter if not the spirit of sharia law, in the view of some tame, pliable and quite possibly corrupt sharia scholar. I am talking about financial innovations that replace debt-type instruments with true profit-, loss- and risk-sharing arrangements.

Mandatory debt-to-equity swaps for the banking sector, conversion of defaulted residential mortgages into equity-sharing instruments for banks and households (possibly for the old stock as well as for the new flow), and the replacement of traditional government debt by GDP growth warrants and similar social risk-sharing instruments could enhance both the ex-ante incentives for risk taking and the ex-post capacity of our economic system to respond to shocks.

http://blogs.ft.com/maverecon/2009/07/islamic-finance-principles-to-restore-policy-effectiveness/

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