Assessing the Nature of Bargaining Powers and the Design of Islamic Banking Institutions Using the Framework by Calomiris and Haber

Assessing the nature of bargaining powers and the design of Islamic banking institutions using the framework by Calomiris and Haber.

By Shahira Johan

Introduction

The relationship between financial sector development and economic development is well researched with proponents on both sides of the arguments. The Austrian Schumpeter (1911) was one of the first economists to develop a model to explain the positive effect of the financial sector on economic growth. On the other hand, the British economist Robinson (1952), argued the opposite and that rather it was the financial sector which benefitted from the state’s economic growth. The extensive body of literature on this subject covers a wide spectrum of real policy questions on the effect of financial sector on not just growth but also general income inequality and overall financial stability. However, despite the increasing sophistication of the global financial markets, the financial sector continues to be marred by scandals and crises. Reinhart and Rogoff’s (2009) This Time Is Different presented a comprehensive assessment of the world’s history of financial crises in the period 1800-2010. Although there have been various types of financial crises, the Harvard economists found that the evidence suggested recessions related to banking crises to be the most expensive^[1]. This is probably not surprising since the public doubly suffers, once from monetary loss due to its private involvement and later when the state’s policy response utilises public funds. Financial crises also disrupt the existing economic trajectory which further exacerbates the socio-economic situation of the people.

Calomiris and Haber (2014)^[2] suggest an explanation from a political economic perspective. They claim that the creation of banking institutions is a result of implicit political bargains over the assignment of property rights and what they refer to as the ‘Game of Bank Bargains’^[3]. They argue that the state’s adopted government-banker partnership has an impact on the stability of the banking system and the economy. As Islamic finance makes further inroads into the world’s economic system, the framework suggested by Calomiris and Haber present a useful tool to articulate and assess the nature of government-banker partnerships in an Islamic financial system. Muslim majority countries historically have not been invincible to financial crises (albeit the main cause for economic stagnation was arguably related to armed conflicts) and the mere adoption of the contractual aspects of Islamic finance is not a sufficient condition for growth and stability. Therefore, it is critical to examine the political economic relationship proposed in the available Islamic economic theories in order to avoid the trappings of financial crises experienced in the conventional sphere.

This paper will attempt to critically compare the proposed government-banker partnerships presented by early Muslim scholars and Islamic economists utilising the political framework presented by Calomiris and Haber. In so doing it is hoped that the paper is able to suggest a cogent political economic framework for an effective and sustainable Islamic financial sector that could be used as a guidance for countries sincerely planning to transition into a full-fledge Islamic financial system.

Government- banker partnerships

Calomoris and Haber claims that “banking is all about politics – and always has been”^[4]. According to them, the banking legal framework is designed to address three property-rights challenges which are (i) government expropriation of banking assets (ii) bank insiders’ expropriation of the minority shareholders’ and depositors’ capital and (iii) bank borrowers’ expropriation from bank insiders, minority shareholders and depositors. The fact that these agents are not independent of each other complicates the bargaining process particularly because the economic incentives of these agents are not inherently aligned^[5]. In the book they state,

‘The allocation of political power determines the composition of coalitions and the deals that they structure. The deals in turn determine which laws are passed, which judges are appointed, and which groups of people have which licenses to contract with whom, for what, and on what terms. They also determine the distribution of the burden of taxation, the allocation of public spending, the regulation of entry, the chartering of banks, the supervision of publicly traded companies, and the flow of credit and its terms. These bargains are exceptionally complex, involving explicit trades and implicit alliances, but at root they are about the creation and distribution of economic rents and the maintenance of political power. They are, in short, the outcome of a strategic interaction – a game, as it were: The Game of Bank Bargains.’^[6]

Calomoris and Haber introduce a taxonomy of regimes and banking systems^[7] to explain the differences in the Game of Bank Bargains. They posit that democratic regimes are more likely to form powerful states where credit is more readily available in the banking system compared to autocratic regimes where the inherent political instability breeds a more volatile banking system which limits access to credit. Despite that, democratic regimes do not always produce stable banking systems as evidenced in Reinhart and Rogoff. Historically, the impact of liberal ideas and the rise of populism in major democracies such as the United States of America and the United Kingdom has led to the formation of various coalitions representing the diverse agents in the banking system which later provided the impetus for the establishment of state-institutions and legal mechanics such as the central bank, deposit insurance and building societies that are primarily concerned with protecting the interests of the respective agents.

 ‘The rise of democracy did more than create fiat money under activist central bank management; it also gave rise to new types of intermediaries that served specialised functions in the new welfare state. Special lending authorities, owned or finance by the government, were created to provide credit to targeted groups of recipients, sometimes identified only by sector (e.g., agriculture or housing) and sometimes by additional characteristics (e.g., small businesses, veterans, or middle-income homeowners). Such targeted lending facilities became powerful tools in the hands of politicians seeking to attract the support of particular constituencies.’^[8]

...