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The time value of money in Islamic finance

Islamic finance and conventional finance are simply different ways of carrying out financial transactions. Accordingly the time value of money is equally applicable to both. However some Islamic finance academics seek to find economic distinctions between the two.

Summary

Posted 18 February 2017

The time value of money is one of the most fundamental principles in finance. Very simply, almost everyone, in almost all circumstances, prefers having money today to having the same amount of money in the future.

It can be quantified by asking people how much money they need to be given in (say) one year's time in exchange for giving up £1 today. If the answer is £1.05, the person's time preference can be quantified as 5% per year.

The extent of the preference differs from person to person. Someone with a very high time preference (say 20% p.a.) may consider it rational to borrow £100 from a lender charging 14% p.a. interest to go on a £100 holiday now, thereby forgoing the opportunity to spend £114 on a better holiday in 12 months time.

Since it is a fundamental principle of finance, the time value of money is applicable to both conventional finance and to Islamic finance. As I have written before, Islamic finance can be defined as finance conducted under the rules specified by Shariah scholars.

Views of Islamic finance academics

Much of the early thinking that gave rise to the modern Islamic finance industry was developed by religious scholars with limited formal education in economics, and even less experience of conventional finance. Accordingly the view seems to have developed amongst some that Islamic finance requires there to be no time value of money.

As such a view is contrary to the way real people, including Muslims, behave, many Islamic finance academics writing more recently have sought to reconcile real world behaviour with the views of the early Islamic finance proponents.

A quick search found the following papers. They are well worth reading. In addition to the views of the papers' authors, they also contain references to other writers who have considered with the same issues.

"Time Value of Money and Discounting in Islamic Perspective: Re-visited" by Monzer Kahf of the Islamic Research and Training Institute, Islamic Development Bank, 1994

"The Time Value of Money Concept in Islamic Finance" by Abu Umar Faruq Ahmad and M. Kabir Hassan (Apparently 2009)

"The Concept of the Time Value of Money: A Shari‘Ah Viewpoint" by Mohamed Fairooz Abdul Khir, International Shari‘ah Research Academy for Islamic Finance, September 2013

"The Concepts of Discounting and Time value of money in Islamic Capital budgeting Framework: A Theoretical study" by Muhammad Abubakar Siddique and Memoona Rahim, January 2015

"Investment Decision Making, Time Value of Money and Discounting in an Islamic Economy" by M. Fahim Khan, Former Chief of Research Division, Islamic Research and Training Institute Islamic Development Bank, now Independent Consultant and Writer.

There are many other papers along similar lines.

At the risk of extreme generalisation, most of them appear to accept that the time value of money and discounting are as integral to Islamic finance as they are to conventional finance, while seeking to find economic distinctions between the ways Islamic banks charge for providing credit and the way that conventional banks charge for providing credit.

I used this as the topic for my January 2017 column in Islamic Finance News, reproduced below.

Letter from Amin January 2017: Murabaha and the time value of money in Islamic finance

Even though the way Islamic banks operate should by now be well understood, I still come across people who contend that there is no concept of the time value of money in Islamic finance. Normally these are young people with no practical experience of Islamic banking.

If you want to buy a car costing $10,000, and don’t have the money but are otherwise creditworthy, a conventional bank may lend you the $10,000 so you can buy the car today. In return, you agree to repay the bank, say, $12,500 in 60 months’ time. (This corresponds to simple interest at 5% for five years.)

If you approach an Islamic bank, they will of course refuse to undertake the above loan transaction. However, assuming you are creditworthy, the Islamic bank will agree to buy that car from the dealer (paying the dealer $10,000) and sell you the car for $12,500 payable in 60 months’ time, while giving you immediate ownership and possession of the car. The net cash flows for you, the bank, and the dealer, both today and in 60 months’ time, are identical.

For accounting purposes, the conventional bank will, of course, record $500 interest income in each of the five years. (This column uses simple interest to avoid clogging up the text with compound interest calculations.)

An Islamic bank accounting under International Finance Reporting Standards will report the same figures as the conventional bank, since IFRS fundamentally accounts for the economic substance of transactions.

An Islamic bank following the standards of the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) is required to apply AAOIFI’s Financial Accounting Standard No. 2 “Murabaha and Murabaha to the Purchase Orderer.” Paragraph 2.4.2 states:

"2.4.2 Profits of a credit sale which will be paid for either by means of one payment due after the current financial period or by instalments over several future financial periods shall be recognized by using one of the following two methods:

a) Proportionate allocation of profits over the period of the credit whereby each financial period shall carry its portion of profits irrespective of whether or not cash is received. This is the preferred method.

b) As and when the instalments are received. This method shall be used based on a decision by the Shari’a supervisory board of the Islamic bank or, if required, by the supervisory authorities."

Under the preferred method, the Islamic bank will also recognise $500 of profit each year.

A quick search will find many articles seeking to distinguish the time value of money in conventional finance and the time value of money in Islamic finance. At the risk of generalising, I consider that the main deficiency of such articles is failure to distinguish between economic analysis and religious analysis.

From an economic perspective, the time value of money is the same in conventional finance and Islamic finance. The economic actors involved are real human beings, whose motivations and attitudes will differ from person to person, but such motivations and attitudes are not neatly classifiable by religion.

The analysis from a religious perspective is a separate issue, and each researcher (indeed each individual Muslim) needs to consider it carefully for themselves. However, this religious question should not be confused with the economic question.

 

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