Financial & Legal Aspects of International Trade

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International Review of Financial Analysis

12 (2003) 405 – 420

Evolution and institutional foundation of the hawala financial system

Matthias Schramm, Markus Taube*

Gerhard-Mercator University Duisburg, Muhlheimer Street 212, Duisburg 47048, Germany

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Abstract

This article examines the evolution and the institutional foundation of the century-old Islamic hawala financing system. Analysis of the functional principles of this system will show that it is a highly efficient, extremely robust institutional arrangement for overcoming the risks of opportunism among the transaction partners. It is an institution that was developed against the backdrop of a lack of formal legal systems. Thus, hawala can be seen as club-like arrangements, which are able to provide the transaction parties with an institutional framework to assure enforcement of contracts without relying on any national law. Today, therefore, it is able to expand outside and independently of existing laws and regulations. It is able to move large amounts of money without recourse of the formal banking system and even without retaining any bookkeeping notes. Instead, it is based on the trust of the participating parties and its social and religious embeddedness within the Islamic community.

D 2003 Elsevier Science Inc. All rights reserved.

JEL classification: F33; G29; P45; Z13

Keywords: Informal financial systems; Islamic banking; Club theory; Social capital; Social embeddedness;

Hawala

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1. Introduction

Investigations after the 9/11 attacks quickly uncovered a worldwide financial system that had for centuries existed largely out of public view: the hawala financial system. Known for centuries in the Islamic world, fundamental Islamic groups had chosen the ancient system to

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* Corresponding author. Tel.: +49-203-379-4188; fax: +49-203-379-4157. E-mail address: markus.taube@uni-duisburg.de (M. Taube).

1057-5219/03/$ – see front matterD 2003 Elsevier Science Inc. All rights reserved. doi:10.1016/S1057-5219(03)00032-2

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become the backbone of their financial structure. But this usage of hawala is only one step in the evolution of hawala banking as a worldwide financial system based on the principles of Islamic banking laws and deeply embedded in the religious and social thinking of the Islamic community. Nevertheless, the question remains: what exactly is hawala, how does it evolve, and what are the underlying working principles.

The following article will try to shed some light on the historical origin and the evolution of hawala through the centuries as well as its present distribution (Section 2). Furthermore, it will try to explain the institutional foundation and the working principles of the hawala financial system (Section 3). In doing so, it will explore the microeconomic rationale behind hawala, its organization, and its embeddedness in the socioeconomic context of the Islamic religious community. Lastly, some conclusions are to be drawn, revealing some problems that hawala poses to the developing Islamic countries.

2. The phenomenon of the hawala financial system

2.1. Historical foundation of hawala

The roots of the hawala financial system can be found in the very early medieval commerce in premodern societies of the Near and Middle East, which contained a multitude of institutional incalculabilities. The merchants of these times operated in an environment that was characterized either by the complete absence of formal systems of order or by formal organization and legal systems that were incomplete and incapable of satisfying all require-ments that arose in increasingly complex business transactions. Furthermore, the regulatory function of existing somewhat inchoate formal legal systems was counteracted by unpre-dictability, arbitrariness, and corruptibility of those civil servants who interpreted them. Thus, anyone attempting to conduct business was faced with the problem that ‘‘the state as an institution that enforces contracts and property rights and provides public goods poses a dilemma: A state with sufficient coercive power to do these things also has the power to withhold protection or confiscate private wealth’’ (Greif, Milgrom, & Weingast, 1994).

Economic interaction was carried out in an environment characterized by the coexistence of smaller regions shaped primarily by tribal law. These regions were only loosely associated through Islam. Thus, the transaction radius within which business could be conducted under the protective wing of a single community was comparatively narrow. Any transactions that reached beyond this radius were encumbered by the constitutional uncertainty inherent in operating in more than one legal system (Schmidt-Trenz, 1990). This problem was ameliorated only by common recognition of the values of the Koran and shari’a as—at least from a moral perspective—legally binding (Ga¨rber, 1992).

Economic transactions were further handicapped by a continuing shortage of means of payment. Silver coins, which were widely accepted, were not universally accessible due to the insufficient availability of silver bullion (Labib, 1969). It was possible, of course, to counteract the stagnation induced by this shortage of currency through the extensive use of bartering in both intra- and interregional commerce (Inalcik, 1969). However, since a barter

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economy is by nature extremely inflexible, new methods of payment had to be found. The evolution of an institutional solution to the problem of coordinating economic interaction was decisively influenced and strongly guided by the Koran’s moral directives as to how business was to be conducted (Amereller, 1995).

In the course of time, however, an extensive group of institutions came into existence, which are collectively referred to today as Islamic banking. Within this early set of institutions, the most varied types of transaction—from delayed payment to bills of exchange—developed into the most common instruments of payment used in medieval commerce (Inalcik, 1969). Eventually, the hawala system established itself as an efficient institutional arrangement.

The Arabic term hawala can be translated as payment or debt transfer (roughly comparable to the roman delegation debiti) but, interestingly, in Hindi it can also mean trust—or to be precise—some valuable artifact that is passed on to a trusted third party for delivery (Spies, 1972).Hawalacan be found as a legal concept as early as in 1327 in one of the firstsystematic explications of Islamic law by the Hanafitic legal scholar Abu Bakr b. Maseud al-Kasani. In its original form, hawala served as a simple delegation of payment or transfer of a claim; however, the various Islamic legal traditions had established differing contractual parameters (Ray, 1997). Basically, such a transaction took the following form:

Person X owes a debt to Person Y, who in turn owes a similar sum to Person Z. In a hawala transaction, Person Y signs over his claim on Person X to Person Z. For X and Z, there is a change in the identity of their respective business partners but not in the amount of their obligation or claim. Y, on the other hand, has balanced his demands and obligations through this transaction and is therefore eliminated from the economic chain of interaction.

Based on this principle and in light of the fact that a debt transfer of this sort could take place even when the parties involved were in different locations, this original interpretation of hawala over the course of centuries developed into a complex and geographically limitless network for transferring sums of money. Thus, from its original purpose as a means of reducing the costs of the technical transaction process, hawala metamorphosed into an institution to decrease the uncertainties and risks involved in (cross-border) business dealings. The transfer of funds within today’s hawala financial network takes place according to the principle diagrammed in Fig. 1.

2.2. Basic principles of hawala nowadays

For centuries, the basic functional principles of hawala stayed nearly the same. Close networks, kinship, trust, and religious conviction remain the basic pillars of this institution although modern communication systems make the actual business transactions much easier.

If a client wishes to transfer a certain sum of money, he meets with the local hawala intermediary in his village, city, or county and tells him the amount of the payment and where and when it has to be made. The hawala intermediary takes the sum and a small additional handling fee calculated according to the amount to be transferred and gives the client a code,

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Fig. 1. Principles of the hawala financial system.

for example, a simple word or a particular verse from the Koran. Then, the intermediary contacts his partner in the relevant target area and, by telephone, fax, or e-mail, tells him the code and the amount to be paid out. In passing on this information, the hawala intermediary in the transaction’s place of origin has completed his part in it. If it has been necessary for him to keep any written record of the transaction up to this time, it can now be destroyed. The client, meanwhile, also uses the usual modern means of communication to tell the recipient the code, which can indicate where the payment will be made. The recipient then contacts the hawala intermediary in the target area (whose identity is also indicated in the code), passes on the code, and accepts payment.

Once the payment has been issued, if not before, the intermediary in the target area destroys any notes or other indications of the transfer. Most hawala transactions are concluded within 24 hours leaving no bookkeeping notes or other evidence of the transfer. Within the network, the financial intermediaries operate according to the ‘‘two-pot’’ system, resorting to a clearing process to balance the sums only if, due to unusually high one-time payment orders or other structural exceptions, it is foreseen that in- and outgoing payments are not likely to balance each other naturally. If it should become necessary, the sums are generally sent by courier in the form of cash or, more likely, jewels, gold, or objets d’art.1 Thus, it is practically impossible for an outsider to connect it to the earlier financial transaction. The hawala financial intermediary does not depend on a complicated infrastruc-ture. All he needs is enough cash to cover the volume of transactions that normally occurs, a notebook, and a cell phone. This does not mean, however, that hawala representatives are not

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1 In case of structural imbalances, like the income transfers of subcontinent workers in the Gulf to their home regions from which no substantial money transfers are directed towards the Gulf, a two (or more) tier system seems to have evolved. Individual ‘‘retail’’ hawaladars settle their balances with a local ‘‘wholesale’’ hawaladar who eventually balances the consolidated local transfer balance with his counterparts in other localities (Wilson, 2002).

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prepared to make use of formal banking and financial systems whenever it suits their needs. For instance, officially established checking accounts have often been used in recent times to pool payments. It would be difficult for outsiders to recognize such subliminal use of the conventional banking system since the accounts are registered to individuals, small busi-nesses, or the like, whose background the bank is unlikely to examine thoroughly. For this reason, the establishment of a ‘‘bank within a bank’’ usually goes unnoticed by the ‘‘host’’ credit institution (Frankfurter Allgemeine Zeitung, 2000).

Considering the lack of transparency inherent in the hawala system, it is understandable that it has been legally banned in almost all the countries of the world—even those which are strongly Islamic, such as Pakistan and Iran. The most significant motive for this ban is the fear that hawala’s continued existence threatens central government’s regulation and control of the nation’s economy since hawala is beyond all the classical instruments of macro-economic policy. A look at the sums of money that are regularly transferred within the network indicates that such concerns are by no means unfounded. Despite the bans, the volume of financial transactions in the hawala network at times substantially exceeds that in the formal banking sector. For example, Pakistan’s finance minister, Shaukat Aziz, estimates that of the U.S.$6 billion transferred within Pakistan in the year 2000, only $1.2 billion were moved through the conventional banking system (Economist, 2001). Between the important Islamic countries of Iran, Pakistan, Afghanistan, and the Arabian Peninsula, in the past few years, some $30 billion have been moved through the hawala network (Spiegel-Online, 2001). It is estimated by national and supranational organizations that every year approx-imately $200 billion move around the globe through hawala networks without ever becoming subject to official regulation of any kind (Intern.de, 2001).

Today, the hawala financial system can be confident of a firm client base in a number of very specific niches, namely those which the formal banking and financial system cannot fill at all or can only fill with high transaction costs. In the formal economic sector, this refers primarily to payment transfers from foreign workers to their families in remote parts of the world that are not sufficiently—if at all—integrated into the modern banking system. Thus, the considerations that have led this group of clients to make hawala networks their preferred financial service providers are most likely practical rather than ideological. However, it is in the ‘‘second economy’’ that hawala provides the broadest range of services; there, it functions as the financial infrastructure for transactions that are not permitted in the formal banking system because they transgress the applicable laws and regulations.

3. Institutional foundation of the hawala financial system

In the historical context depicted above, hawala networks can be seen as the product of evolution, as institutions that have contributed to the further lowering of transaction costs in an economy with an already highly complex division of labor, thus enabling complex exchange relationships—especially in interregional and international commerce. Their ability to provide a mechanism for safeguarding transactions in an environment insufficiently regulated by law is just as relevant today as it was in the early Middle Ages. The hawala

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financial institution of today has continued to develop and adapt to current conditions, which are dramatically different.

The coordination problem solved by hawala can be seen—for both the historical and the present-day forms of the system—as the lack of an impartial third party who could enforce the fulfillment of the contractual arrangement. Whereas, in the early Middle Ages, the need resulted from the lack of formal regulatory mechanisms, it today continues because of the ban on hawala. The actors who use hawala today are acting outside civil law in the countries in which they conduct their financial business. The individual economic parties are thus forced to develop an institutional arrangement that makes it possible to ensure the fulfillment of their respective contractual obligations. This requires a situation in which each party involved in the transaction has a personal interest in the fulfillment of the contract and considers a long-term continuation of the business relationship more useful than its opportunistic termination). The need for this is clear, as it can be assumed that (at least to some extent) rational economic parties, who are seeking to maximize their profits, will terminate contractual relationships when they anticipate that doing so will bring them greater benefit (Telser, 1980).

From the perspective of the new institutional economics (NIE), this problem can be solved either through a relational contract based on a horizontal interaction pattern or through the transfer of a transactional relationship in a hierarchical regulatory system. In addition to these two coordination mechanisms, the NIE considers the market a third elemental regulator in economic processes based on the division of labor. However, market-coordinated relation-ships are only suitable for the coordination of transactions as long as there is an externally imposed regulatory framework, i.e., if the transaction takes place under the protective wing of a general societal consensus, which particularly protects the property rights of the partners. It follows that markets cannot contribute to the regulation of tribal or cross-border transactions (Williamson, 1979).

Hawala networks represent a solution to this problem based on chains of relational contracts coordinated by its various financial agents. They break down a direct transaction between the economic parties that would be encumbered by prohibitively high transaction costs and risks into a series of transactions, whereby transaction costs and risks are reduced to a level that does not impede completion.

There are two basic forms of business relationship in a hawala contractual arrangement: The core transaction between the financial agents and the peripheral transactions between the individual agents and their clients. These two types of transaction are subject to various coordination mechanisms, as will be more closely examined below. But first, the regulatory principles of the core transactions, which form the basis of the hawala financial system, will be investigated.

3.1. Safeguarding core transactions

Cooperative behavior within core transaction of the hawala system can be guaranteed through the establishment of a special informal organization, the hawala—network, which permeates the entire business relationship (Williamson, 1985). To analyze these networks, the economic theory of clubs mostly assigned to James M. Buchanan (1965) appears to be

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fruitful. The analysis of (economic) clubs was meant to bridge the gap between ‘‘purely private’’ and ‘‘purely public’’ goods. Thus, a club good is nongovernmental alternative to the provision of a public good ‘‘that are excludable and subject to some rivalry in the form of congestion’’ (Sandler & Tschirhart, 1997). Following this, a club is a voluntary group of people gaining mutual benefits from sharing either production costs, special members’ characteristics, or a good that can be characterized by excludable benefits (Sandler & Tschirhart, 1980).

From an institutionalistic point of view hawala networks can be seen as homogeneous clubs. They guarantee their members the enforceability of available property rights in an institutionally disorderly environment as well as lower transaction costs (in the form of setup and various other management costs) compared with a nonclub solution. Such financial systems based on homogeneous clubs are also developed in other cultures in response to similar problems. In China, during the Tang dynasty (618–907AD), an interregional payment system known as fei qian (flying money) was practiced for purposes of tax payment or commerce between provinces far removed from one another. Moreover, it is known that, in the medieval commercial center of Bruges,

a great number of payments—certainly most payments among businessmen—were made by ‘‘assignment in bank’’. [. . .] In Bruges it was not only possible to transfer credit when the debtor and the creditor were both clients of the same money-changer, but also when the debtor was client of one money-changer, and the creditor, the client of another money-changer. [. . .] all money-changers were in account with one another. There were fifteen money-changers in Bruges at the time of Collard de Marke. His ledger significantly contains fourteen clearing accounts with other money-changers. (Roover, 1942)

Thus, in an environment missing the provision of the public good ‘‘contractual/legal security,’’ these networks, including hawala, provide a club good solution to this problem. The hawala network establishes legal safeguards for its members in the disposition of property rights within the framework of economic transactions2 in that it embeds one-shot games (one-time-only transactions between isolated economic parties), which are subject to opportunism, in an iterative system of multiple games (transactions with other club members) (Axelrod, 1983). Finally, the system also ensures that people fulfill their contractualobligations because of the rapid spread of information through the network as to who is trustworthy and who is not (Goudie & Stasavage, 1998). Trustworthy, cooperative behavior is rewarded by the continuing ability to carry out low-cost transactions with the network members. Opportunism, on the other hand, is punished by the withdrawal of goodwill or even expulsion from the network (Wank, 1999). Thus, the affected party suffers not only the loss of the investment necessary to join the network, but also a massive rise in the cost of future transactions (Kranton, 1996)—in some cases at such a prohibitively high level that it may

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2 In this context, the club, in accordance with Sandler, becomes a ‘‘nongovernmental alternative to the optimal provision of a class of public goods’’ (Sandler & Tschirhart, 1997).

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mean complete withdrawal from his field of operation (Buskens, 1999). Thus, ‘‘performance is implicitly enforced by the threat of termination of the transactional relationship and communication of the contractual failure to the marketplace’’ (Klein, 1985). The possible consequences of contractual failure are demonstrated so drastically, that interest in oppor-tunism is discouraged, and, thereby, general adherence to both formal and informal rules is ensured (Schmidt-Trenz, 1990).

At this point, determining the optimal size of such a club is central (Buchanan, 1965). The more members there are, the harder it becomes to guarantee the ubiquitous enforcement of sanctions against infringements. If the optimal club size is exceeded, i.e., too many members are joining the club, it increases the cost to the members of information concerning infringements by individuals (Carr & Landa, 1983). If these crowding effect occur punishment of bad faith can no longer always be guaranteed. In the case of hawala networks, crowding effects, for all intents and purposes, cannot occur. An in-depth analysis of these clubs will show the special economic and social architecture that is meant to prevent crowding effects.

First, club membership endows the individual with a certain identity and reputation. Only in this way is it possible for trust to be established between the individual partners in a transaction, thus alleviating the uncertainty inherent in ‘‘faceless’’ transactions. This trust can only be translated into ‘‘secured expectations’’ (Dasgupta, 1988) if the relevant transaction partner has been identified as a fellow club member. The attempts described above to establish and preserve one’s reputation as a trustworthy club member can be seen as (specific) investments in social capital (Dasgupta & Serageldin, 1999; Williamson, 1985) In other words, the shared capital in clubs like hawala networks is composed of accumulated social capital. This stabilizes the existence of the clubs in that it takes on the characteristics of sunk cost. Any club member who was to be expelled from the club would irrevocably lose his social capital expenditures. Each member therefore has strong material incentives to behave in accordance with club statutes, not only to enjoy the returns on his investments but also to avoid the complete write-off of his invested capital. However, investment in the social capital of a hawala network must also be seen from another perspective as a specific investment in Williamson’s (1985) sense. The fact that the nature of hawala networks is at least to some extent religious renders the diversification of invest-ments in social capital and with it the reduction of social risks impossible: The tie to a religious system of the radical nature described (and assumed) here is much the same as a high, specific investment that prevents (social) transactions with other religious or social groups from ever taking place. In other words, the choice of membership in such a club— and with it the construction and bond of social capital—is not only final but also exclusive. Diversification of transaction potential and, with it, risk reduction is not possible (Marko-witz, 1965). At the same time, however, the decision to join this kind of club is irreversible(indeed, bringing with it a potential threat to one’s livelihood), so that the decision itself can be interpreted as a reliable and credible signal to other club members of one’s trustworthi-ness (Williamson, 1983). After all, the punitive power of the club cannot be circumvented by substituting transactions carried out in alternative systems for the transactions with club members lost through opportunism.

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Second, credible signals of trustworthiness are especially provided by ethical and religious identifying features (Iannaccone, 1998). Timur Kuran (1995) shows that

[a] factor that has fueled economic Islamization is that an Islamic subeconomy helps its participants cope with the prevailing adversities by fostering interpersonal trust. [. . .] Their shared commitment to Islam, even if partly feigned, keeps many of their activities within social circles in which information about dishonest behavior spreads quickly, thus providing a basis for mutual trust.

Examining the hawala networks in this light, one’s attention is drawn to the strict adherence to Islamic law. Shari’a claims to represent a supranational code of law (Zahraa, 2000). Therefore, in theory, it can serve to secure transactions that go beyond ‘‘secular’’legal jurisdictions, so that the regulatory problem that prompted the development of hawala networks in the first place should actually never have occurred at all. In practice, however, shari’a was and is handicapped in this role because, first, there is no supranational judiciary and executive to enforce it and, second, its validity is not recognized by all economic entities. Thus, in spite of its claim of universal validity, shari’a can only take on regulatory functions in religious ‘‘islands’’ where the community recognizes its validity and enforces its legal principles. But since such religious communities, or at least members of them, are scattered around the globe, shari’a continues to function as a rival to the mostly state-run legal systems of the world. Against this background, at least a number of the hawala financial networks are clubs that look to the Koran for their guiding principles and establish shari’a as the law for their members and execute it. Accordingly, these organization take over governmental functions inas-much as they administer justice in an area in which the formal juridical system is considered by definition to have no jurisdiction (Anderson, 1995; Posner, 1980). The basic characteristic in such a club that makes possible the identification of members and the development of trust between them would thus be mutual recognition of shari’a or identification with common religious principles and values. As Skaperdas and Syropoulos (1995) shows:

the long-rung success of gangs and primitive states depends heavily on the articulation and internalization by members, subjects and community of a workable ideology, a logically connected system of beliefs about the world.

Connected with this is the willingness to subject oneself to an automatic mechanism of sanctions with the threat of excessive punishment, whereby one’s credibility as a trustworthy business partner is convincingly signaled within the religious community.

The mechanisms described above lead to a situation in which, in most cases, the increasing advantages of maintaining a long-term business relationship significantly outweigh any short-term profit that might result from an opportunistic breach of contract. Therefore, the network members behave in accordance with their contractual obligations.

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3.2. Safeguarding peripheral transactions

In addition to the core transactions, which form the central network, the peripheral transaction are necessary for the development of the functioning financial system. These peripheral transactions must be subject to a security mechanism that prevents opportunism and ensures the fulfillment of contractual obligations.

Hawala has been banned almost everywhere so the parties have no recourse to a codified institutional framework that would ensure the fulfillment of contractual obligations. Since both parties are thus operating outside the national (or regional) legal system, enforcement of the relational contracts between clients and hawala financial intermediaries can only be guaranteed through an informal institutional. At first sight, opportunism appears to be made possible by the distinctive information asymmetries: In a hawala transaction, over a relatively long period, a potential information deficit develops to the detriment of the client, since he must first rely on the intermediary to fulfill his task. However, in the evolution of hawala networks, particular solutions have been developed to resolve such problems. These solutions are able to counteract institutional incalculabilities and decrease information deficits. Thus, there is inherent protection against possible information asymmetries because of the sophisticated commun-ication system within the hawala financial system (Greif, 1989), as shown in Fig. 2.

As shown in Fig. 2, the business client (BC [a]) places an order with his financial intermediary (FI [1]) for the payment of a certain sum of money and gives him that amount. The hawala intermediary provides the client with a specific code, which the client must then pass on to the recipient of the money in the target area (BC [b]). The intermediary in the network hub where the payment is to be issued (FI [2]) also receives the code—both from his partner in the network and from business client (b). At this point, the circle of communication within the hawala network has been perfectly completed: Both business client (a), who has

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Fig. 2. Information flow and individual transactions in hawala banking.

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initiated the payment order, and business client (b), the recipient of the payment, know the sum to be transferred, so that neither FI (1) nor FI (2) has any informational leeway. Moreover, feedback is possible at all times on both levels—that of the clients and that of the financial intermediaries. The transaction between the financial intermediaries is safeguarded through the arrangements immanent in the network. Should unintentional information asymmetries occur between the clients, one can still assume that the information exchanged within the hawala network is roug