Impact of Debt Financing on EBIT of Firm–Introduction Part 1

In finance, capital structure refers to the way a corporation finances its assets. A firm can be financed by 100% equity or with some mix of equity and debt. It is an important decision, how the assets of a firm are financed i-e what should be the financing mix? Should the firm be financed with 100 equity or with some mix of equity and debt? The finance literature on the subject of capital structure is extensive but yet to come up to any definite answer.

Equity in finance is defined as the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. Debt imply intent to pay a fixed periodic payment and pay back an amount owed by a specific date, which is set forth in the repayment terms. It has a claim ahead of equity on the earnings of the firm.

Does capital structure choice of a firm matter? In financial literature related to the question of financing mix of a firm, we find five major strands of research viz.

1. Tax Based Theories
2. Agency Costs Theories
3. Signaling Theories
4. Pecking Order Theories
5. Information Asymmetry Theories

 Modigliani Miller (1958) argued that under certain assumptions value of the firm is independent of how its assets are financed i-e its capital structure. Later in (1963) they revised their famous MM proposition by saying that the existence of tax subsidies on interest payments would cause the value of the firm to rise with the amount of debt financing by the amount of the capitalized value of the tax subsidy. For value of the firm to increase in case of debt financing because of larger cash inflows due to tax subsidy is only possible when EBIT of the firm remains the same no matter how the assets are financed. So, essentially they argued that EBIT of the firm would be independent no matter how the capital is divided among equity and debt. Jensen and Meckling (1976) argued that the firm is not an individual. It is a legal fiction which serves as a focus for a complex process in which the conflicting objectives of individuals (some of whom may “represent” other organizations) are brought into equilibrium within a framework of contractual relations. In this sense the “behavior” of the firm is like the behavior of a market, that is, the outcome of a complex equilibrium process. If the behavior of the firm is “the outcome of complex equilibrium process” – balancing act of value maximization of different stakeholders given the positive monitoring and bonding costs then it cannot be said that its operations are independent of its choice of capital structure. They further argued that Modigliani-Miller theorem is based on the assumption that the probability distribution of the cash flows to the firm is independent of the capital structure. It is now recognized that the existence of positive costs associated with bankruptcy and the presence of tax subsidies on corporate interest payments will invalidate this irrelevance theorem precisely because the probability distribution of future cash flows changes as the probability of the incurrence of the bankruptcy costs changes, i.e., as the ratio of debt to equity rises. The existence of agency costs provide stronger reasons for arguing that the probability distribution of future cash flows is not independent of the capital or ownership structure. They went on to assert that debt carries covenants that limit management’s ability to take optimal actions on certain issues and that would reduce the profitability of the firm. In general the revenues or the operating costs of the firm are not independent of the probability of bankruptcy and thus the capital structure of the firm. As the probability of bankruptcy increases, both the operating costs and the revenues of the firm are adversely affected, therefore, its EBIT of the firm cannot be independent of how it is financed. Stephen A. Ross (1977) advocated that implicit in the irrelevancy proposition is the assumption that the market knows the (random) return stream of the firm and values this stream to set the value of the firm. What is valued in the marketplace, however, is the perceived stream of returns for the firm. Putting the issue this way raises the possibility that changes in the financial structure can alter the market's perception. Value of a firm will rise in case of debt financing because it will signal to the market that EBIT of the firm would be sufficient enough to meet its obligations. The reason was that any change in financial structure of the firm changes its perception in the market about its earnings stream and when leverage is increased, it is perceived in the market that the firm has expectations of strong earnings stream. So, in his opinion, if the firm decides to finance future expansion or change its financial structure with debt, it is because that firm expects a strong earnings stream and so the value of the firm would increase. Stewart C. Myers (1984) argued that optimal debt ratio in capital structure is determined by tradeoff of benefits and costs of debt financing by holding constant the firm’s assets and investment plans. Benefits of debt are interest tax shields whereas costs include various costs of bankruptcy and financial distress. If there were no adjustment costs then each firm’s debt-to-value ratio should be its optimal ratio. But there are adjustment costs and time lag as the firms move toward their target debt ratio that is why there is observable dispersion in debt ratios in cross section of data. He cited a study by Donaldson (1961) that states “Management strongly favored internal generation as a source of new funds even to the exclusion of external funds except for occasional unavoidable ‘bulges’ in the need for fund.” He further cited Donaldson “Given that external finance was needed, managers rarely thought of issuing stock.” This behavior of managers is due to asymmetric information and costs of financial distress. Because of asymmetry of information, managers are unwilling to issue equity if market undervalue new issue of equity. If the firm does seek external funds, it is better off issuing debt than equity securities. The general rule is, "Issue safe securities before risky ones." What if the managers' inside information is unfavorable, so that any risky security issue would be overpriced? In this case, wouldn't the firm want to make /\N as large as possible, to take maximum advantage of new investors? If so, stock would seem better than debt (and warrants better still). The decision rule seems to be, "Issue debt when investors undervalue the firm, and equity, or some other risky security, when they overvalue it.” If the manager with superior information acts to maximize the intrinsic value of existing shares, then the announcement of a stock issue should be bad news, other things equal, because stock issues will be more likely when the manager receives bad news. On the other hand, stock retirements should be good news. The news in both cases has no evident necessary connection with shifts in target debt ratios.It is assumed that EBIT of the firm is independent from source of financing. It does not matter as far as EBIT is concerned how the new investment opportunity is financed. It is a matter of perception in the market due to asymmetry of information that changes the value of the firm. Stewart C. Myers and Nicholas S. Majluf (1984) argued that because of asymmetry of information new stockholders assume that  management acts in the interests of 'old' (existing) stockholders. If managers have inside information there must be some cases in which that information is so favorable that management, if it acts in the interest of the old stockholders, will refuse to issue shares even if it means passing up a good investment opportunity. That is, the cost to old shareholders of issuing shares at a bargain price may outweigh the project's NPV. Investors, aware of their relative ignorance, will reason that a decision not to issue shares signals 'good news'. The news conveyed by an issue is bad or at least less good. This affects the price investors are willing to pay for the issue, which in turn affects the issue-invest decision. Under these circumstances, a firm with ample financial slack - e.g., large holdings of cash or marketable securities, or the ability to issue default-risk-free debt - would take all positive-NPV opportunities. The same firm without slack would pass some up and if external financing is required will prefer debt to equity. This model also assumes that EBIT of a firm is independent of its choice of financing mix, it is the discount rate that varies with the perception of investors about a particular choice of financing mix.

Difference in Cash and Credit Price and Islamic Finance

Difference of cash and credit price charged by suppliers looks like Time value of Money and in Islam charging for time in relation to money is prohibited as Riba. Is it so? The answer can be found by analyzing what is Riba, nature of money in Islamic Economics, Time Value of Money and rulings on credit transactions.

Usury from Medieval Latin usuria, "interest", or from Latin usura, "interest") originally was the charging of interest on loans; this included charging a fee for the use of money, such as at a bureau de change. In places where interest became acceptable, usury was interest above the rate allowed by law. Today, usury commonly is the charging of unreasonable or relatively high rates of interest. The term is largely derived from Christian religious principles; Riba is the corresponding Arabic term and ribbit is the Hebrew word. "When money is lent on a contract to receive not only the principal sum again, but also an increase by way of compensation for the use, the increase is called interest by those who think it lawful, and usury by those who do not." (Blackstone's Commentaries on the Laws of England, p. 1336).

The Holy Qur'an did not give any definition for the term for the simple reason that it was well known to its immediate audience. It is like the prohibition of pork, liquor, gambling, adultery etc, which were imposed without giving any hard and fast definition because all these terms were well known and there was no ambiguity in their meaning. Similar was the case of riba. It was not a term foreign to Arabs. They all used the term in their mutual transactions. Not only Arabs but all the previous societies used to practice it in their financial dealings and nobody had any confusion about its exact sense.

Hadith while explaining the word riba has mentioned in detail the transactions of riba which were used to be effected by the Arabs of Jahiliyya on the basis of which the earliest commentators of the Holy Qur'an have defined riba in clear terms. Imam Abubakr Al-Jassas (D.380 AH) in his famous work Ahkamul Qur'an has explained riba in the following words: "And the riba which was known to and practiced by the Arabs was that they used to advance loan in the form of Dirham (silver coin) or Dinar (gold coin) for a certain term with an agreed increase on the amount of the principal advanced." On the basis of this practice the same author has defined the term in the following words: "The riba of Jahiliyya is a loan given for stipulated period with a stipulated increase on the principal payable by the loanee." The well-known Imam Fakhruddin Al-Raazi has mentioned the practice of riba in the days of Jahiliyya as follows: "As for the riba An-Nasiah, it was a transaction well-known and recognized in the days of Jahiliyya i.e. they used to give money with a condition that they will charge a particular amount monthly and the principal will remain due as it is. Then on the maturity date they demanded the debtor to pay the principal. If he could not pay, they would increase the term and the payable amount. So it was the riba practiced by the people of Jahiliyya."

The claim of an increased amount over the principal had different forms in the days of Jahiliyya. Firstly, while advancing a loan the creditor used to claim an increased amount over the principal and would advance loan on this clearly stipulated condition as is mentioned by Imam Al-Jassas in his Ahkamul Qur'an already quoted above. Secondly, the creditor used to charge a monthly return from the debtor while the principal amount would remain intact up to the day of maturity as mentioned by Imam Ar-Raazi and Ibn Aadil already quoted. The third form is mentioned by Mujahid, but the full explanation of this transaction is given by Ibn Jarir himself on the authority of Qatadah in the following words: "The Riba of Jahiliyya was a transaction whereby a person used to sell a commodity for a price payable at a future specific date, thereafter when the date of payment came and the buyer was not able to pay, the seller used to increase the amount due and give him more time." The same explanation has been given by al-Suyuti on the authority of Faryabi in the following words: "They used to purchase a commodity on the basis of deferred payment, then on the date of maturity the sellers used to increase the due amount and increase the time of payment." This form of Riba has been frequently mentioned by the commentators of the Holy Qur'an because they wanted to explain a particular sentence of the verses of Riba which is as follows: "The non-believers say that sale is very similar to Riba." (Aya 275 of Sura Al-Baqarah). This saying of the non-believers clearly refers to the particular transaction of sale mentioned above. Their objection was that when we increase the price of commodity in the original transaction of sale because of its being based on deferred payment, it is treated as a valid sale. But when we want to increase the due amount after the maturity date, when the debtor is not able to pay, it is termed as Riba while the increase in both cases seems to be similar. This objection of the non-believers of Makkah has been specifically mentioned by the famous commentator Ibn Abi Hatim on the authority of Said ibn Jubair: "They used to say that it is all equal whether we increase the price in the beginning of the sale, or we increase it at the time of maturity. Both are equal. It is this objection which has been referred to in the verse by saying 'They say that the sale is very similar to Riba.'” The same explanation is given in al-Bahr al-Muheet by Abu Hayyan and several other original commentators of the Holy Qur'an. It clearly shows that the practice of increase at the time of maturity relates to two situations: firstly, a situation where the original transaction was that of sale of a commodity as mentioned by Qatadah, Faryabi, Saeed Ibn Jubair etc, and the second situation was where the original transaction was that of a loan whereby monthly interest used to be charged by the creditor and the principal amount used to remain intact until the date of maturity, and if the debtor would not pay the principal at that point of time, the creditor used to increase the due amount on the principal in exchange of further time given to debtor. It is thus established that the Riba prohibited by the Holy Qur'an was not confined to one transaction only. It had different forms which all were practiced by the Arabs of Jahiliyya. The common feature of all these transactions is that an increased amount was charged on the principal amount of a debt. At times, this debt was created through a transaction of sale and it was created through a loan. Similarly, the increased amount was at times charged on monthly basis, while the principal was to be paid at a stipulated date, and some time it was charged along with the principal. All these forms used to be called Riba because the lexical meaning of the term is increase. That is why, the commentators of the Holy Qur'an like Imam Abu bakr al-Jassas have defined the term in the following words: "The Riba of Jahiliyya is a loan given for a stipulated period against increase on the principal payable by the Loanee."

One of the wrong presumptions on which all theories of interest are based is that money has been treated as a commodity. It is, therefore, argued that just as a merchant can sell his commodity for a higher price than his cost, he can also sell his money for a higher price than its face value, or just as he can lease his property and can charge a rent against it, he can also lend his money and can claim interest thereupon.

Imam Al-Ghazzali (d.505 A.H.) the renowned jurist and philosopher of the Islamic history has discussed the nature of money in an early period when the Western theories of money were non-existent. He says:

"The creation of dirhams and dinars (money) is one of the blessings of Allah…. They are stones having no intrinsic usufruct or utility, but all human beings need them, because every body needs a large number of commodities for his eating, wearing etc, and often he does not have what he needs and does have what he needs not.. Therefore, the transactions of exchange are inevitable. But there must be a measure on the basis of which price can be determined, because the exchanged commodities are neither of the same type, nor of the same measure which can determine how much quantity of one commodity is a just price for another. Therefore, all these commodities need a mediator to judge their exact value…. Allah Almighty has, therefore, created dirhams and dinars (money) as judges and mediators between all commodities so that all objects of wealth are measured through them… and their being the measure of the value of all commodities is based on the fact that they are not an objective in themselves. Had they been an objective in themselves, one could have a specific purpose for keeping them which might have given them more importance according to his intention while the one who had no such purpose would have not given them such importance and thus the whole system would have been disturbed. That is why Allah has created them, so that they may be circulated between hands and act as a fair judge between different commodities and work as a medium to acquire other things…. So, the one who owns them is as he owns every thing, unlike the one who owns a cloth, because he owns only a cloth, therefore, if he needs food, the owner of the food may not be interested in exchanging his food for cloth, because he may need an animal for example. Therefore, there was needed a thing which in its appearance is nothing, but in its essence is everything. The thing which has no particular form may have different forms in relation to other things like a mirror which has no color, but it reflects every color. The same is the case of money. It is not an objective in itself, but it is an instrument to lead to all objectives…

So, the one who is using money in a manner contrary to its basic purpose is, in fact, disregarding the blessings of Allah. Consequently, whoever hoards money is doing injustice to it and is defeating their actual purpose. He is like the one who detains a ruler in a prison…

And whoever effects the transactions of interest on money is, in fact, discarding the blessing of Allah and is committing injustice, because money is created for some other things, not for itself. So, the one who has started trading in money itself has made it an objective contrary to the original wisdom behind its creation, because it is injustice to use money for a purpose other than what it was created for…. If it is allowed for him to trade in money itself, money will become his ultimate goal and will remain detained with him like hoarded money. And imprisoning a ruler or restricting a postman from conveying messages is nothing but injustice."

Time value of Money has been defined as The idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. Money that you hold today is worth more because you can invest it and earn interest. After all, you should receive some compensation for foregoing spending. A key concept of TVM is that a single sum of money or a series of equal, evenly-spaced payments or receipts promised in the future can be converted to an equivalent value today.  Conversely, you can determine the value to which a single sum or a series of future payments will grow to at some future date. The basic idea of time value of money is that a Rupee today is worth more than a Rupee tomorrow. This can be shown in many ways, many people find it easiest to understand if they think in terms of something they already know: food. For example having the money today allows you to buy some food immediately. Alternatively you may be willing to forgo current consumption and wait until later to purchase your food. Thus you could lend your "food money" to another with the promise of being paid back at some future time. Since you are passing up food today you would demand a return sufficient to allow you to buy at least as much food in the future that you are giving up now. As we do not know the future this type of deal involves risks. For example the borrower may decided to not pay you back. This is called default risk. Or the borrower may pay you back but due to rising prices you can no longer purchase the same amount of food as you had expected to be able to buy. As a result of these risks (you as a lender) would require a higher interest rate to compensate for accepting the risks. However if you ask for too high of interest rates you will not find any takers for your loan.

Islam acknowledges an increment in a commodity’s price in any sale contract to be paid at a future date, as long as money’s time value is not claimed as a predetermined value. In other words, any conditional increase in the loan’s principal in return for a deferred repayment due to an expected depreciation in the value of the money, asset, or other factors (e.g., inflation and commercial losses) is prohibited. The following few quotations from traditional jurists exemplify that increasing the price of a commodity for delay is acceptable:

1. Al-Kasani (Hanafi) in Bada’i`i al-Sana’i`i: “The price may be increased based on deferment.”
2. Ibn Rushd (Maliki) in Bidayat al-Mujtahid: “He has given time a share in the price.”
3. Al-Nawawi (Shafi`i) in Al-Majmu`: “Deferment earns a portion of the price.”
4. ‘Ibn Taymiyah (Hanbali) in his Fatawa: “Deferment takes a share of the price.”

This is tantamount to the acceptance of time value in the pricing of goods. What is prohibited is any addition to the commodity’s price once it has been mutually agreed upon, because of any delay in its payment. Such a prohibition also suggests that Islam does not permit a fixed predetermined time value for money. The reasons behind the permissibility of increasing the price of a commodity in credit sales  is that once the commodity is sold, even on credit, the purchaser retains its ownership on a permanent basis, and thus the seller has no right to reprice the sold commodity, since it no longer belongs to him/her. Jalal al-Din al-Suyuti (d. 911/1507) and Ibn Jarir al-Tabari (d. 310/922) reported the similar situation of involvement with riba in which a person sold a commodity on credit; when the payment was due and the purchaser could not repay it, the price was increased and the time for payment was extended. Imam Tirmidhi (d. 279/857) reported that the Prophet (pbuh) forbade “two sales in a single contract.”

Following is a Hadith from Al-Muwata 31.74, which throws some light on the term “Two Sales in One Sale”.

Yahya related to me from Malik that he had heard that al-Qasim ibn Muhammad was asked about a man who bought goods for 10 dinars cash or fifteen dinars on credit. He disapproved of that and forbade it.

Malik said that if a man bought goods from a man for either 10 dinars or 15 dinars on credit, that one of the two prices was obliged on the buyer. It was not to be done because if he postponed paying the ten, it would be 15 on credit, and if he paid the ten, he would buy with it what was worth fifteen dinars on credit.

Malik said that it was disapproved of for a man to buy goods from someone for either a dinar cash or for a described sheep on credit and that one of the two prices was obliged on him. It was not to be done because the Messenger of Allah, may Allah bless him and grant him peace, forbade two sales in one sale. This was part of two sales in the one sale.

Malik spoke about a man saying to another, "'I will either buy these fifteen sa of ajwa dates from you, or these ten sa of sayhani dates or I will buy these fifteen sa of inferior wheat or these ten sa of Syrian wheat for a dinar, and one of them is obliged to me.' Malik said that it was disapproved of and was not halal. That was because he obliged him ten sa of sayhani, and left them and took fifteen sa of ajwa, or he was obliged fifteen sa of inferior wheat and left them and took ten sa of Syrian wheat. This was also disapproved of, and was not halal. It resembled what was prohibited in the way of two sales in one sale. It was also included under the prohibition against buying two for one of the same sort of food."

Islamic jurists have explained this to mean that, for instance, if a person tells someone: “I will sell this cloth for ten (dirhams) in cash and on credit for twenty (dirhams)” and, at separation, one price is not settled. If one of the two prices is settled, he sale is valid. Al-Tirmidhi also added that if a seller says: “I sell the cloth for 10 (dirhams) cash and 20 (dirhams) on credit” and the buyer accepts one of these prices or says: “I will purchase it for 20 (dirhams) on credit,” or the parties differ on the price, the sale is still valid.

While it is best to buy an article by paying cash, it is also permissible to buy on credit by mutual consent. A group of jurists are of the opinion that, should the seller increase his price if the buyer asks for deferred payments, as is common in installment buying, the price differential due to the time delay resembles interest, which is likewise a price for time; accordingly, they declare such sales to be haram. However, the majority of scholars permit it because the basic principle is the permissibility of things, and no clear text exists prohibiting such a transaction. Furthermore, there is, on the whole, no resemblance to interest in such a transaction, since the seller is free to increase the price as he deems proper, as long as it is not to the extent of blatant exploitation or clear injustice, in which case it is haram. Al-Shawkani says, "On the basic of legal reasons, the followers of Shafi'i and Hanafi schools, Zaid bin 'Ali, al-Muayyid Billah, and the majority of scholars consider it lawful." (Nayl al-awtar,vol. 5, p. 153. Al-Shawkani said, "We have compiled a treatise on this subject and have called it 'Shifa al'ilal fi hukum ziyadat al-thamam li mujarrad al-ajal' (The Reason for Increasing the Price Due to Lapse of Time), and have researched it thoroughly.")

The condition for the credit price to be different from cash price of a commodity is that the parties to transaction must settle one price before parting otherwise the difference of cash and credit price is not permitted.When one of the price is settled, seller cannot change the price based on any change in payment period as this would constitute Riba.

Money’s time value is acceptable in the case of pricing assets and their usufruct, it is not acceptable in the case of any addition to the loan’s or debt’s principal. Time valuation is possible only in business and the trade of goods, not in the exchange of monetary values and loans or debts, as the Shari`ah considers a loan to be a virtuous act from which one cannot take any benefit. Therefore, no time value can be added to a loan’s or a debt’s principal after it has been created or the purchaser’s liability has been stipulated.

Yusuf Al-Qaradawi has followed the footsteps of Hazrat Umar (RAA) who said that “We have given up 90% of all legitimate transactions for the fear that an element of Riba might be present in them.” When you are in doubt about a transaction whether it involves an element of Riba or not just give up.

Financial Crisis and Academic Conflict of Interest

Islam prohibits a behavior that is in conflict of one’s responsibilities. Here is an Aya from Quran and commentary. The Aya and commentary is very relevant to the subject under discussion.

And do not eat up your property among yourselves for vanities nor use it as bait for the judges with intent that ye may eat up wrongfully and knowingly a little of (other) people's property. Aya 188 of Sura Al-Baqara

Besides the three primal physical needs of man, which are apt to make him greedy, there is a fourth greed in society, the greed of wealth and property. The purpose of fasts is not completed until this fourth greed is also restrained.
Ordinarily honest men are content if they refrain from robbery, theft, or embezzlement. Two more subtle forms of the greed are mentioned here. One is where one uses one's own property for corrupting others - judges or those in authority - so as to obtain some material gain even under the cover and protection of the law.
The words translated "other people's property may also mean "public property". A still more subtle form is where we use our own property or property under our own control - "among yourselves" in the Text - for vain or frivolous uses. Under the Islamic standard this is also greed. Property carries with it its own responsibilities. If we fail to understand or fulfil them, we have not learnt the full lesson of self-denial by fasts. Commentary By Abdullah Yusuf Ali

Academicians are the forerunners of practitioners. They observe a certain phenomena and try their best to explain it so that behaviors of practitioners can be moulded accordingly for the benefit of public at large. Rules and regulations are the outcome of such observations, empirical analyses, academic debate etc.

In the wake of current financial crisis, there is a need for an unbiased analyses by the academia so that causes for such crises in the future can be controlled. But unfortunately there are some grey areas that need to be addressed like biasness for example. There are growing reports that academia was involved in the financial meltdown.

Here is an excerpt from an article

Over the last thirty years, academic economics has been penetrated by special interests, particularly financial services, in the same way that America’s political and regulatory systems have been compromised by campaign contributions and the revolving door.  In fact, the “revolving door” is now a triangular trip between industry, government, and academia.

Prominent economists are now routinely paid to testify in antitrust cases, criminal trials, and regulatory proceedings; to testify in Congress; to give speeches to the industries and firms they study; to serve on boards of directors and as advisors; and to write supposedly objective analyses of industries, companies and policies. These payments and the conflicts of interest they generate are rarely disclosed, except when required by Federal law.

These activities are not marginal; they are now, literally, a billion dollar industry, managed by firms such as the Law and Economics Consulting Group (LECG), The Analysis Group, Compass Lexecon, Charles River Associates, and others.  Professors’ income from such groups often dwarfs their academic salaries.  That neither universities nor most publications require such disclosure was one of the most shocking facts I learned while making Inside Job, my documentary on the financial crisis.

More recently, American Economic Association has recognized this moral hazard and has announced to adopt a code of ethical standards for its members. Following is an excerpt from The New York Times article on the subject.

Academic economists, particularly those active in policy debates in Washington and Wall Street, are facing greater scrutiny of their outside activities these days. Faced with a run of criticism, including a popular movie, leaders of the American Economic Association, the world’s largest professional society for economists, founded in 1885, are considering a step that most other professions took a long time ago — adopting a code of ethical standards.

The proposal, which has not been announced to the public or to the association’s 17,000 members, is partly a response to “Inside Job,” a documentary film released in October that excoriates leading academic economists for their ties to Wall Street as consultants, advisers or corporate directors.

Here is another excerpt from an article

In October, Gerald Epstein and Jessica Carrick-Hagenbarth released a paper documenting potential conflicts of interests among academic economists writing about the financial crisis and financial reform. Focusing on the Squam Lake Working Group on Financial Regulation and the Pew Economic Policy Group Financial Reform Project, they found that a majority of the economists involved had affiliations with private financial institutions, yet few of them disclosed those affiliations even in academic publications (where they do not face the word constraints imposed by print newspaper editors), preferring to identify themselves by their universities and as members of prestigious institutions such as NBER. To be fair, they did not find a strong relationship between economists’ affiliations and their positions on financial reform, perhaps because of the small sample and the limited amount of variation in the positions of members of these groups.

Following is an excerpt from a letter written by Epstein and Carrick-Hagenbarth to the president of the AEA asking for the adoption of a code that requires economists to avoid conflicts of interest and to disclose ties that could create the appearance of a conflict of interest.

More specifically we propose that the AEA adopt a code modeled on that of the American Sociological Association. This code could state that: “Economists should maintain the highest degree of integrity in their professional work and avoid conflicts of interest and the appearance of conflict. Moreover, economists should disclose relevant sources of financial support and relevant personal or professional relationships that may have the appearance or potential for a conflict of interest in public speeches and writing, as well as in academic publications.”

This issue has taken on greater salience as the recent financial crisis has highlighted economists’ potentially conflicting roles that may have affected their real or perceived impartiality as analysts and experts. For example, in an assessment of 19 economists who have played prominent and influential roles in recent public policy debates, Gerald Epstein and Jessica Carrick-Hagenbarth found that 13 out of 19 economists had private financial affiliations indicative of some possible conflicts of interest, but only 5 had clearly and publicly revealed their affiliations. A Reuters study of Congressional testimony by academics (many but not all of whom are economists) analyzed “… 96 testimonies given by 82 academics to the Senate Banking Committee and the House Financial Services Committee between late 2008 and early 2010 — as lawmakers debated the biggest overhaul of financial regulation since the 1930s.”  They found that “…roughly a third (of the academics) did not reveal their financial affiliations in their testimonies, based on a comparison of the text of their testimonies available on the Congressional committees’ websites with their resumes available online.”

From reading all the above reports, one can easily get that there is something wrong and under the existing arrangement of academia and financial industry, it is hard to accept that they will come up with some un biased analyses and reforms that are in the interest of the public at large. Unless and until the profession does not enforce transparency and code of ethical standards, ill advised policy is a real danger.

One way to keep your debt down is to bring a loss frame to your loan statement

Here is a reproduction of a very useful technique to remind oneself to keep the debt figure down. The description is in the context of credit card statement but can be applied to credit facility statement as well.


"Nudge blog reader and Booth School grad Fakhr Mokadem thinks there is a way to reframe credit card statements to keep people from overspending. Instead listing the balance as a positive amount, Mokadem wants to list it as a negative.

For instance, say I have a credit limit of $10,000 and I have spent $8,500 throughout the month. Usually a credit card statement would read: – Credit $8,500. Available balance $1,500. This lets people feel that they have room to spend…

What if I had the following statement: You are -$8,500 and you can go down to -$10,000.

Framing the statement this way makes feel that you should move up to zero, rather than trying to stay below $10,000.

Mokadem says he tries to read his statements this way in order to motivate himself to keep his debt down. “Instead of feeling that I have a right to spend up to my available balance, I feel that I am under water or really in debt,” he says."

Nudge blog · Trying to keep your debt down? Bring a loss frame to your credit card statement

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Islamic Banking and Finance is not Islamic anymore

There are concerns that the development of Islamic banking and Finance is more in line with its counterpart than indigenous Islamic. Islamic Finance is different than its counterpart on many fronts like interest, risk ,halal, haram, bankruptcy to name few. Here is an excerpt from an article that pointedly said that Islamic Banking and Finance is not Islamic anymore.

"The credit crunch has sponsored much discussion on the need for a new approach to banking and finance. While the Islamic financial system has been mentioned as a possible alternative in this regard, it is widely recognized that this system has itself been largely modeled on its interest-based counterpart. Both share the same material goals and adopt the same institutional structures, with the result that the products promoted by the Islamic finance industry are often indistinguishable from those of interest-based institutions."

"These similarities have led some insiders to concede that the Islamic banking and finance industry has failed to properly implement the ideals upon which it was founded more than thirty years ago. They fear that a gradual merger between Islamic and interest-based finance is taking place, encouraged by commercial and political factors. Others wonder how such a vital function of Muslim society can be founded upon contractual devices that so many of its scholars reject, the enforceability of a promise being a particularly widespread case in point."

"A serious and nimble response to these concerns is often hindered by a lack of intellectual honesty within the Islamic finance industry itself. Platforms are rarely provided to scholars who wish to take one step back and question some of the fundamental concepts that are being applied. Few questions are raised regarding the validity of Islamic debt financing, limited liability structures, speculative methods of market trading, or the nature of the monetary system. Such matters are given little attention in the headlong rush to copy interest-based methodologies and this has resulted in a number of embarrassing paradoxes. For example, while some Islamic investment managers attempt to develop Shari`ah compliant short-selling techniques, several western authorities are banning the practice on account of the instability that it causes. Most serious of all is the fact that, having copied the western template of finance, the Muslim world is in no position to point to a viable alternative at this time of crisis. In a few short months, thirty years of strategy have been debunked, and our industry leaders are left with little to say."

Aya 280 of Sura Al-Baqara

Ayat 275 to 279 of Sura Al-Baqara

Aya 65 of Sura Al-Baqara

Aya 163 of Sura Al-A'raf

Don't put a question mark where, Allah puts a full stop.

"According to dictionary, the word Islam, from the tri literal root s-l-m, is derived from the Arabic verb Aslama, which means "to accept, surrender or submit. “ A Muslim (Arabic: مسلم ) an adherent of the religion of Islam. The feminine form of 'Muslim' is Muslimah (Arabic: مسلمة ). Literally, the word means "one who submits to God".

“If anyone is looking for a religion other than Islam, then let it be known that it will not be accepted from him; and in the Hereafter he will be among the losers.” (Sura Al’i-Imran Aya No. 85)." Dīn (دين, also anglicized as Deen) is an Arabic word usually translated as "religion" but also as "way of life", especially referring to Islam, known as ad-dīn "the deen", or dīn al-haqq "the true deen" (e.g. ayat 48:27, 9:33 = 61:9). It is, however, not exclusive to Islam, as Arab Christians also use it to refer to their religion and religion in general. The word “Deen” appears in as many as 79 Qur'anic verses and it is often translated as religion for convenience since there is no equivalent single satisfactory English word. In the Qur'an, Islam is always referred to as Dīn. It is the sum total of a Muslim's faith and the code and conduct necessary to submit to Allah's laws.

Hence, it can be said that Islamic Finance is conducting financial and business matters according to the commandments of Allah(SWT) expressed or implied.

Credit transactions are not to be taken as a routine matter as in business no one has enough capital to give time to debtor till they are able to pay the amount and nor can everyone write them off as charity even if it is the best and it is the best because Allah(SWT) has said so. Therefore, there is no concept of banking in Islam where the business model is borrowing and subsequent lending.

Credit transactions are injurious to Muslims on two accounts. As a creditor, on account of giving respite to debtor in difficulty, disturbance in cash flows leading to default in payment in case of back to back Murabahah and seemingly loss of capital in case of write off to charity. As a debtor, there is no exemption from payment of debt unless it is written off by creditor. His heirs are liable to pay the debt. I quote Ahadith in this connection.

Shaih Muslim 872

Narrated Amr ibn al-'As "The Messenger of Allah (peace be upon him) said: All the sins of a Shahid (martyr) are forgiven except debt."

Al-Tirmidhi

Narrated AbuHurayrah "The Prophet (peace be upon him) said: The soul of a deceased believer is held back on account of his debt till the debt is discharged."

Another very important Hadith on debt based transaction is

Sahih Al-Bukhari 1.795

"Narrated Aisha (the wife of the Prophet) Allah's Apostle used to invoke Allah in the prayer saying "Allahumma inni a'udhu bika min adhabil-qabri, waa'udhu bika min fitnatil-masihid-dajjal, wa a'udhu bika min fitnatil-mahya wa fitnatil-mamati. Allahumma inni a'udhu bika minal-mathami wal-maghrami. (O Allah, I seek refuge with You from the punishment of the grave and from the afflictions of Masiah Ad-Dajjal and from the afflictions of life and death. O Allah, I seek refuge with You from the sins and from being in debt)." Somebody said to him, "Why do you so frequently seek refuge with Allah from being in debt?" The Prophet replied, "A person in debt tells lies whenever he speaks, and breaks promises whenever he makes (them)." 'Aisha also narrated: I heard Allah's Apostle in his prayer seeking refuge with Allah from the afflictions of Ad-Dajjal."

The following sentence from the above Hadith is of particular importance to Muslims "A person in debt tells lies whenever he speaks, and breaks promises whenever he makes (them)." So, there is every possibility of default. 

Why companies manage their earnings?

 Joseph Grundfest and Nadya Malenko analyzed almost half a million earnings reports from 1980-2006. They discovered that when companies want to appear more successful than they are, they often massage their per-share earnings numbers upward by a tenth of one cent. 


Why earnings management?


Consistent with analyst coverage being a determinant of earnings management, quadrophobia increases (declines) when companies gain (lose) analyst coverage, and is more frequent when earnings are close to analyst forecasts."


Why analysts' coverage is required? In my opinion asymmetry of information about business between outsiders and insiders.


Quran says: Ayat 8 - 16 of Sura Al-Baqara


First the characteristics of people who lie.

1. Of the people there are some who say: "We believe in Allah and the Last Day" but they do not (really) believe.
2. Fain would they deceive Allah and those who believe but they only deceive themselves and realize (it) not!

Then the reasons why people lie.

1. In their hearts is a disease; and Allah has increased their disease and grievous is the penalty they (incur) because they are false (to themselves).

Then the symptoms of people who lie.

1. When it is said to them: "Make not mischief on the earth" they say: "Why we only want to make peace!"
2. Of a surety they are the ones who make mischief but they realize (it) not.
3. When it is said to them: "Believe as the others believe" they say: "Shall we believe as the fools believe?" nay of a surety they are the fools buy they do not know.
4. When they meet those who believe they say: "We believe" but when they are alone with their evil ones they say: "We are really with you we (were) only jesting."

Then the benefit cost analysis of lying.

1. Allah will throw back their mockery on them and give them rope in their trespasses; so they will wander like blind ones (to and fro).
2. These are they who have bartered guidance for error: but their traffic is profitless and they have lost true direction. 

Predicting the Next Enron - Freakonomics Blog - NYTimes.com

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Don't underestimate even small loan

The story of a student loan that is considered "good debt" because an education can lead to a higher salary.

When Michelle Bisutti, a 41-year-old family practitioner in Columbus, Ohio, finished medical school in 2003, her student-loan debt amounted to roughly $250,000. Since then, it has ballooned to $555,000.

It is the result of her deferring loan payments while she completed her residency, default charges and relentlessly compounding interest rates. Among the charges: a single $53,870 fee for when her loan was turned over to a collection agency.

"Maybe half of it was my fault because I didn't look at the fine print," Dr. Bisutti says. "But this is just outrageous now."

To be sure, Dr. Bisutti's case is extreme, and lenders say student-loan terms are clear and that they try to work with borrowers who get in trouble.

But as tuitions rise, many people are borrowing heavily to pay their bills. Some no doubt view it as "good debt," because an education can lead to a higher salary. But in practice, student loans are one of the most toxic debts, requiring extreme consumer caution and, as Dr. Bisutti learned, responsibility.

The debt load keeps her up at night. Her damaged credit has prevented her from buying a home or a new car. She says she and her boyfriend of three years have put off marriage and having children because of the debt.

Dr. Bisutti told her 17-year-old niece the story of her debt as a cautionary tale "so the next generation of kids who want to get a higher education knows what they're getting into," she says. "I will likely have to deal with this debt for the rest of my life."

Allah says

If the debtor is in a difficulty grant him time till it is easy for him to repay. But if ye remit if by way of charity that is best for you if ye only knew.  Aya 280 of Sura Al-Baqara

Here is an advise from Prophet Mohammad (PBUH)

Narrated Aisha

Allah's Apostle used to invoke Allah in the prayer saying, "O Allah, I seek refuge with you from all sins, and from being in debt." Someone said, O Allah's Apostle! (I see you) very often you seek refuge with Allah from being in debt. He replied, "If a person is in debt, he tells lies when he speaks, and breaks his promises when he promises."  Sahih Bukhari 3.582

the-555000-student-loan-burden: Personal Finance News from Yahoo! Finance

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Islamic Finance is Different

Islamic Finance as the name suggests is finance according to the Law, Rules & Regulations of Allah (SWT) and His Messenger Muhammad (PBUH). It is not just Arabic names of conventional banking products. It is also not just Riba free. It is to accept, surrender or submit to the will of Allah (SWT).

Dr. El- Gamal posted an eye opener, which states ""Islamic finance" started with a suggestion that the "Islamic economics" philosophy rests on sharing in profits and losses through partnership (i.e. equity) finance. In practice, of course, the industry moved toward debt finance, where the only risk is default risk. Now, they want to insure against credit risk as well, which is of course possible, but defeats the entire purpose."

In Islamic teachings, according to the Quran, an insolvent person should be allowed time to be able to pay out his debt. This is recorded in the Quran's second chapter (Sura Al-Baqara), Verse 280, which notes: "If the debtor is in a difficulty, grant him time till it is easy for him to repay. But if ye remit it by way of charity, that is best for you if ye only knew."

Narrated Abu Huraira


The Prophet said, "There was a merchant who used to lend the people, and whenever his debtor was in straitened circumstances, he would say to his employees, 'Forgive him so that Allah may forgive us.' So, Allah forgave him." Sahih Al-Bukhari 3.292

After clear instructions from Allah (SWT) and His Messenger Muhammad (PBUH), we still want our debt to be secured by Takaful and yet claim to be practicing Islamic Banking & Finance.


The above referred Aya consists of two parts. First part, "If the debtor is in a difficulty grant him time till it is easy for him to repay." Second part, "if ye remit if by way of charity that is best for you if ye only knew." As far as I have researched and obvious from the tone, the first part of the verse is an order from Allah (SWT) and is a mandatory, it has to be obeyed. Second part of the verse is more like a recommendation of best practice, one may adopt it or not.

Should not there be a clause in every debt based Islamic Banking contract so as to incorporate the above mentioned order of Allah(SWT)?

Be Careful in Interpreting "Riba"

In the context of interpretation of Quranic term "Riba", it is very important to have "Taqwa" i-e one should be conscious of the express or implied commands of Allah (SWT). As there is no respite from pretense or ignorance. Following two references are very much relevant.

Those who devour usury will not stand except as stands one whom the Evil One by his touch hath driven to madness. That is because they say: "Trade is like usury but Allah hath permitted trade and forbidden usury. Those who after receiving direction from their Lord desist shall be pardoned for the past; their case is for Allah (to judge); but those who repeat (the offence) are companions of the fire: they will abide therein (for ever).

Aya 275 Sura Al-Baqara

Narrated Anas

The Prophet said, "On the Day of Resurrection the Believers will assemble and say, 'Let us ask somebody to intercede for us with our Lord.' So they will go to Adam and say, 'You are the father of all the people, and Allah created you with His Own Hands, and ordered the angels to prostrate to you, and taught you the names of all things; so please intercede for us with your Lord, so that He may relieve us from this place of ours.' Adam will say, 'I am not fit for this (i.e. intercession for you).' Then Adam will remember his sin and feel ashamed thereof. He will say, 'Go to Noah, for he was the first Apostle, Allah sent to the inhabitants of the earth.' They will go to him and Noah will say, 'I am not fit for this undertaking.' He will remember his appeal to his Lord to do what he had no knowledge of, then he will feel ashamed thereof and will say, 'Go to the Khalil-r-Rahman (i.e. Abraham).' They will go to him and he will say, 'I am not fit for this undertaking. Go to Moses, the slave to whom Allah spoke (directly) and gave him the Torah.' So they will go to him and he will say, 'I am not fit for this undertaking,' and he will mention (his) killing a person who was not a killer, and so he will feel ashamed thereof before his Lord, and he will say, 'Go to Jesus, Allah's Slave, His Apostle and Allah's Word and a Spirit coming from Him. Jesus will say, 'I am not fit for this undertaking, go to Muhammad the Slave of Allah whose past and future sins were forgiven by Allah.

' So they will come to me and I will proceed till I will ask my Lord's Permission and I will be given permission. When I see my Lord, I will fall down in Prostration and He will let me remain in that state as long as He wishes and then I will be addressed: '(Muhammad!) Raise your head. Ask, and your request will be granted; say, and your saying will be listened to; intercede, and your intercession will be accepted.' I will raise my head and praise Allah with a saying (i.e. invocation) He will teach me, and then I will intercede. He will fix a limit for me (to intercede for) whom I will admit into Paradise. Then I will come back again to Allah, and when I see my Lord, the same thing will happen to me. And then I will intercede and Allah will fix a limit for me to intercede whom I will let into Paradise, then I will come back for the third time; and then I will come back for the fourth time, and will say, 'None remains in Hell but those whom the Quran has imprisoned (in Hell) and who have been destined to an eternal stay in Hell.' " (The compiler) Abu 'Abdullah said: "But those whom the Qur'an has imprisoned in Hell," refers to the Statement of Allah:

"They will dwell therein forever." (16.29)

Sahih Al-Bukhari 6:3

These two quoted references are self explanatory and need no further explanation than one should have extreme care in interpreting the meaning of term "Riba" otherwise the consequences are extreme and there is no respite.

The word "care" does not capture the entire behavior and the spirit that is required. The word that can capture the required behavior is "Taqwa". The very first order by Allah (SWT) in Quran is in Aya 21 of Sura Baqara, which says "O ye people! adore your Guardian-Lord who created you and those who came before you that ye may have the chance to learn righteousness." The comment on this Aya from Abdullah Yousuf Ali is worth reading.

"I connect this dependent clause with "adore, etc." above, though it could be connected with "created". According to my construction the argument will be as follows. Adoration is the act of the highest and humblest reverence and worship. When you get into that relationship with Allah, Who is your Creator and Guardian, your faith produces works of righteousness. It is a chance given you: will you exercise your free will and take it? If you do, your whole nature will be transformed." The very first guidance from Allah (SWT) for the mankind is to learn "Taqwa" because without having it one can't come to possess the understanding of His message, the way He wants to be understood.

So in matters of Allah (SWT), there is no other way except to have "Taqwa". Following are some of the interpretations of the term "Taqwa", which shall make it clear what is required while interpreting the literal meaning and terms of Quran.

Tafseer ibn Kathir mentions that Atiyah As-Sa’di said the Propeht (pbuh) said, “The servant will not acquire the status of those with taqwa until he abandons what is harmless out of fear of falling into that which is harmful.” [Ibn Majah, Tirmidhi]

Sayyiduna Ali (R.A) defined Taqwa as being the ‘fear of Jaleel (Allah), acting upon the tanzeel (Quran), being content with qaleel (little), and preparing for the day of raheel (journeying from this world).

Hazrat Umar ibn Khattab (R.A) once asked Hazrat Ibn Ka’ab (R.A) the definition of taqwa. In reply Hazrat Ibn Ka’ab asked, “Have you ever had to traverse a thorny path?” Hazrat Umar replied in the affirmative and Hazrat Ka’ab continued, “How do you do so?” Hazrat Umar (R.A) said that he would carefully walk through after first having collected all loose and flowing clothing in his hands so nothing gets caught in the thorns hence injuring him. Hazrat Ka’ab said, “This is the definition of taqwa, to protect oneself from sin through life’s dangerous journey so that one can successfully complete the journey unscathed by sin.”

The confusion around the interpretation of the term "Riba" is intentional one to mislead people for the purposes of some ulterior motives. Some of them have taken refuge in the comments of Hazrat Umar (R.A) about the interpretation of the term "Riba". These people have taken Hazrat Umer’s (RAA) remarks to mean that Riba is a vague term whose meanings were not obvious even to the closest companions of the Prophet (PBUH). They further claimed that whatever has been written on Riba is the personal interpretation of religious scholars and jurists.

The tradition which reports the remark by Hazrat Umar (RAA) that he could not check full details of certain kinds of Riba with the Prophet (PBUH) also includes the words “so give up Riba and whatever may appear akin to Riba.” Hazrat Umar (RAA) himself followed his recommendation to the hilt “We have given up 90% of all legitimate transactions for the fear that an element of Riba might be present in them.” (Reported By Imam Shafi)

Use of Arabic Names for Islamic Financial Contracts

It seems that there is almost a quiet understanding that a financial product to be within the realm of Islamic Finance needs an Arabic name, translation into other languages e.g in English would be detrimental to the very purpose. To name a few of such contracts are

1. Musharika
2. Mudaraba
3. Ijara
4. Murabaha

Their translation can be as follows

1. Partnership
2. Joint Venture
3. Leasing
4. Cost Plus Profit

Is there any harm in it? In my opinion, it would be much easier for understanding the Islamic Finance viz-a-viz Conventional Finance, if we use the modern most easily understood terms.

Islamic Finance and Bankruptcy

Bankruptcy is a legally declared inability or impairment of ability of an individual or organization to pay its creditors. Creditors may file a bankruptcy petition against a debtor ("involuntary bankruptcy") in an effort to recoup a portion of what they are owed or initiate a restructuring. In the majority of cases, however, bankruptcy is initiated by the debtor (a "voluntary bankruptcy" that is filed by the insolvent individual or organization).

The concept and origin of bankruptcy law as it is now known in the United States originated in England. The first English bankruptcy law is generally agreed to have been enacted in 1542. Actually, bankruptcy was originally planned as a remedy for creditors - not debtors. During the reign of King Henry VIII., bankruptcy law allowed a creditor to seize all of the assets of a trader who could not pay his debts. Additionally, on top of losing all of one's property, the unfortunate debtor also lost his freedom and was subject to imprisonment for failure to pay his debts. This left the family of the debtor in the position of having to pay the debts in order to obtain the release of the debtor. As time progressed, however, so did the rights of debtors in England. In the 1700s, for example, debtors were often released from prison and many fled to the United States to live. Many immigrated to Georgia and Texas, which became known as debtors’ colonies. Finally, by the early 1800s in England, debtors were often released from prison and their debts discharged. However, for many years, bankruptcy continued to be a remedy favoring creditors, involuntary in nature and largely penal in character. It was generally used only against traders.

In ancient Greece, bankruptcy did not exist. If a man (since only locally born adult males could be citizens, all legal owners of property were men) owed and he could not pay, he and his entire household, whether wife, children or servants were forced into "debt slavery", until the creditor recouped losses via their physical labor. Many city-states in ancient Greece limited debt slavery to a period of five years and debt slaves had protection of life and limb, which regular slaves did not enjoy. However, servants of the debtor could be retained beyond that deadline by the creditor and were often forced to serve their new lord for a lifetime, usually under significantly harsher conditions.

Bankruptcy is also documented in East Asia. According to al-Maqrizi, the Yassa of Genghis Khan contained a provision that mandated the death penalty for anyone who became bankrupt three times.

The principal focus of modern insolvency legislation and business debt restructuring practices no longer rests on the elimination of insolvent entities but on the remodeling of the financial and organizational structure of debtors experiencing financial distress so as to permit the rehabilitation and continuation of their business. There are two forms of bankruptcy that are in common practice. First, where a debtor surrenders his or her non-exempt property to a bankruptcy trustee who then liquidates the property and distributes the proceeds to the debtor's unsecured creditors. Second, the debtor retains ownership and control of its assets and is re-termed a debtor in possession ("DIP"). The debtor in possession runs the day to day operations of the business while creditors and the debtor work with the Bankruptcy Court in order to negotiate and complete a plan. Upon meeting certain requirements (e.g. fairness among creditors, priority of certain creditors) creditors are permitted to vote on the proposed plan. If a plan is confirmed the debtor will continue to operate and pay its debts under the terms of the confirmed plan. If a specified majority of creditors do not vote to confirm a plan, additional requirements may be imposed by the court in order to confirm the plan. Bankruptcy can also be classified by two types from the point of view of creditor and debtor. When creditors enforce bankruptcy, it is called compulsory and when debtor seeks protection from creditors, it is called voluntary.

In Islamic teaching, according to the Quran, an insolvent person should be allowed time to be able to pay out his debt. This is recorded in the Quran's second chapter (Sura Al-Baqara), Verse 280, which notes: "If the debtor is in a difficulty, grant him time till it is easy for him to repay. But if ye remit it by way of charity, that is best for you if ye only knew."

Here are two ahadith of Prophet (PBUH) on the subject.

Narrated Abu Huraira

The Prophet said, "There was a merchant who used to lend the people, and whenever his debtor was in straitened circumstances, he would say to his employees, 'Forgive him so that Allah may forgive us.' So, Allah forgave him." Sahih Al-Bukhari 3.292

Narrated Abdullah ibn AbuQatadah

AbuQatadah demanded (the payment of his debt) from his debtor but he disappeared; later on he found him and he said: I am hard up financially, whereupon he said: (Do you state it) by God? He said: By God. Upon this he (Qatadah) said: I heard Allah's Messenger (peace be upon him) said: He who loves that Allah saves him from the torments of the Day of Resurrection should give respite to the insolvent or remit (his debt). Sahih Muslim 740

Narrated Salama bin Al Akwa

Once, while we were sitting in the company of Prophet, a dead man was brought. The Prophet was requested to lead the funeral prayer for the deceased. He said, "Is he in debt?" The people replied in the negative. He said, "Has he left any wealth?" They said, "No." So, he led his funeral prayer. Another dead man was brought and the people said, "O Allah's Apostle! Lead his funeral prayer." The Prophet said, "Is he in debt?" They said, "Yes." He said, "Has he left any wealth?" They said, ''Three Dinars." So, he led the prayer. Then a third dead man was brought and the people said (to the Prophet ), Please lead his funeral prayer." He said, "Has he left any wealth?" They said, "No." He asked, "Is he in debt?" They said, ("Yes! He has to pay) three Diners.', He (refused to pray and) said, "Then pray for your (dead) companion." Abu Qatada said, "O Allah's Apostle! Lead his funeral prayer, and I will pay his debt." So, he led the prayer. Sahih l-Bukhari 3.488A

Narrated AbuQatadah

The Messenger of Allah (peace be upon him) stood up among them (his companions) to deliver his sermon, in which he told them that Jihad in the cause of Allah and belief in Allah (with all His Attributes) were the most meritorious of acts. A man stood up and said: Messenger of Allah, do you think that if I am killed in the cause of Allah, my sins will be blotted out from me? The Messenger of Allah (peace be upon him) said: Yes, in the case where you are killed in the way of Allah, you were patient and sincere and you always fought facing the enemy, never turning your back upon him. Then he added: What have you said (now)? (Wishing to have further assurance from him for his satisfaction), he asked (again): Do you think if I am killed in the say of Allah, all my sins will be obliterated from me? The Messenger of Allah (peace be upon him) Said: Yes, if you were patient and sincere, and always fought facing the enemy, never turning your back upon him, (all your lapses shall be forgiven) except debt. Gabriel has told me this. Sahih Muslim 871

Narrated AbuSa'id al-Khudri

In the time of Allah's Messenger (peace be upon him) a man suffered loss in fruits he had bought and his debt increased; so Allah's Messenger (peace be upon him) told (the people) to give him charity and they gave him charity, but that was not enough to pay the debt in full, whereupon Allah's Messenger (peace be upon him) said to his creditors: "Take what you find, you will have nothing but alms." Sahih Muslim 738

Narrated Jabir ibn Abdullah

The Apostle of Allah (peace be upon him) would not say funeral prayer over a person who died while the debt was due from him. A dead Muslim was brought to him and he asked: Is there any debt due from him? They (the people) said: Yes, two dirhams. He said: Pray yourselves over your companion. Then AbuQatadah al-Ansari said: I shall pay them, Apostle of Allah. The Apostle of Allah (peace be upon him) then prayed over him. When Allah granted conquests to the Apostle of Allah (peace be upon him), he said: I am nearer to every believer than himself, so if anyone (dies and) leaves a debt, I shall be responsible for paying it; and if anyone leaves property, it goes to his heirs. Sunnan Abu-Dawood 1482

From the foregoing deliberations, it is clear that in Islamic Finance there is no concept of bankruptcy either forced or voluntary. It is the responsibility of the debtor to pay his debt and after his death it becomes the responsibility of the heirs, community and state in this particular order to arrange for payment of the debt of the deceased.