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SOVEREIGN MAN

Why Islam can save your wealth

Long ago, physical commodities were used as a mediums of exchange… gold and silver were quite popular because they were scarce, divisible, durable, and hard to replicate.

If you had a few extra ounces laying around and wanted to store it securely, you would seek out the people who dealt with precious metals all the time and had the right equipment and staff to keep it safe.  At the time, those were goldsmiths.

In exchange for keeping your wealth safe, goldsmiths would charge a fee… and for that fee, you could drop by any time and withdraw some of your gold on demand.

In other cases, if you wouldn’t be needing your gold for a while, you could leave it with him for a fixed period, say 1-year. In this case, the goldsmith would pay you interest on the deposit, knowing that he could loan out the gold to someone in need of capital at a higher rate for the same duration.

It was a simple, admirable system. When you wanted your money, it was there; if you didn’t need it, you could earn a return.

Over time, the system changed. Goldsmiths (turned bankers) began issuing paper notes which were redeemable for the gold that was secured in their vaults. The paper notes circulating around town were ‘as good as gold,’ depending on the bank’s reputation.

Occasionally, a greedy banker would circulate too many notes around town– $100,000 worth of gold in the vault, $110,000 worth of notes circulating around town. The banker got rich, and no one really noticed… until $110,000 became $150,000 became $200,000.

Then suddenly, noticing the spike in money supply, the townspeople would lose confidence in the note and descend on the bank to demand their gold. The banks collapsed and depositors took it on the chin.

Naturally, governments eventually became involved.  They standardized a single paper currency for the country and took charge of securing the nation’s gold reserves.  In the United States, perhaps the greatest change took place in 1913.

After intense Congressional deliberation, Woodrow Wilson signed the Federal Reserve Act into law in December of that year. Aside from creating the United States Federal Reserve, the Act created a regulatory structure for a nationwide fractional reserve banking system.  And from that day forward, every bank in the country became effectively insolvent.

Fractional reserve banking is the practice of loaning out more money than is on deposit. Someone deposits $10 in a bank; the banker keeps $1 in the vault and loans out the other $9. That $9 makes its way through the economy and is eventually deposited in the bank. The banker keeps $0.90 and loans out the other $8.10.

This scheme is repeated over and over again until there is $100 floating around the economy based on a single deposit of $10.  An additional $90 was conjured out of thin air by the bank.

Suppose you went to a storage facility and paid them to secure your furniture… if the facility owners went behind your back and loaned out your kitchen table, this would constitute fraud.  Yet in banking, this is standard practice thanks to the Federal Reserve Act.

The Fed governs the ‘reserve ratio,’ which is the amount of deposits that banks actually have to keep on hand. Depending on the type of deposit, it ranges from 0% to 10%.

The system works when everyone has confidence. When they don’t, banks go under– and that is exactly what is happening right now.  Between balance sheet deterioration and loss of depositor confidence, banks are dropping like flies… but hey, don’t worry, the taxpayers have you covered.

Personally, I want to put my money in a place where the bank will actually hang on to it and no one has to rely on a taxpayer bailout.

One solution that you won’t hear too many people talk about is Islamic Banking.  Based on the ‘Shariah’ principles of Islamic law, Islamic banks in theory must hold 100% of their demand deposits in reserve.

In practice, thanks to creative deals and a bit of leniency from Muslim scholars, the reserve ratio is a bit less than 100% for Islamic banks… but as a whole, their reserves and financial strength are extraordinarily higher than western banks that are on the fractional reserve system.

If you are concerned about what another financial meltdown will do to your bank account, consider opening an account at an Islamic bank. Abu Dhabi Islamic Bank in the UAE is one example– they work with US citizens and even have safety deposit boxes for rent.  ADIB has branches across the country, including in Dubai.

Outside of the Gulf region, Singapore and Malaysia are two up-and-coming Islamic Banking centers that have interesting tax advantages. Malaysia is particularly interesting because of its tax-free Labuan region.  I’ll be discussing this in future letters.

As a final note this afternoon– I know Turkey day is tomorrow in the United States even though it will just be Thursday here in Asia, but I will likely refrain from email for the next two days and talk with you again on Monday.

And don’t forget that next Tuesday will be the 2nd release of the Panama Black Paper– only 25 copies will be sold, so if you want a copy, make sure you sign up to be on our pre-notification list. 12/1/2009 update: We received a lot of feedback from subscribers around the world in ‘inconvenient’ time zones that would be unavailable for the pre-notification launch… I understand this more than most people– 12pm on the east coast is the middle of the night in Sydney. Consequently, we are sending out a public notification on December 1st will keep it open for 24-hours.

About the author: Simon Black is an international investor, entrepreneur, permanent traveler, free man, and founder of Sovereign Man. His free daily e-letter and crash course is about using the experiences from his life and travels to help you achieve more freedom.

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Comments on this entry are closed.

  • Fiercely Independent John Nada

    **Excellent article…really thinking “outside the box”. I’m not a finance guy as my portfolio consists mostly of less liquid assets (real estate), but I’m definitely interested in perhaps opening an Islamic account after taking in this point of view.

    Thanks for posting it.
    FYONNL!
    Fiercely Independent John Nada

  • BFT

    Good to have you here on Phuket. If you’re craving for stuff other than thai food be sure to visit White Box, on the main beach road to kamala/surin on your left hand a few kilometers from Patong. Very nice gourmet restaurant, which costs about the same as 2 burgers and a coke back home. Their beef and foie gras are awesome.

  • Leland

    I thought I’d say that, if you perform the same analysis as is detailed in the excellent explanation in this article, it is clear that short selling in the stock market also makes it into a fractional reserve system (with a 50% reserve ratio rather than a 10% reserve ratio). Brokers are legally allowed to “loan” out stocks that their customers own (with no contractual obligation to make them whole). When they do that, no matter how it is explained, they end up with at least 2 people each having an unencumbered claim to the same underlying share (one being the short seller and the other being the original owner, whose claim is covered by a potentially worthless IOU from the short seller). Here also, the scheme is repeated over and over again until there are many people each with an unencumbered claim to the same share. Sadly, all but one of those people actually own a potentially worthless IOU.

    As with the fractional reserve banking system, this inflates the number of outstanding shares and dilutes the value of each share just as would the issuance of more shares without any corresponding increase in the underlying assets of the company. It really is exactly the same fraudulent situation as is described in this newsletter (where a warehouse owner or goldsmith loans out other people’s on-demand property or provides counterfeit warehouse receipts to multiple people) because people owning shares of a stock have the right to demand them back from their broker (sell them) at any time. Just as is described in this article, eventually, people lose confidence in the stock and there is a “run” on the stock where all begin to demand them back from their broker (to sell them) at which time the stock price collapses because most of the outstanding shares are, at that point, worthless (counterfeit) IOUs. Obviously, this doesn’t happen with every share subject to short selling, just as there are seldom runs on banks in the fractional reserve banking system, and sometimes it can backfire on the short seller, when they greatly misjudge the stock’s price trend and have to cover their IOU at a loss, but you can be certain it does happen.

    And the truly wretched thing about it is that the short seller (who made his money up front by selling the shares borrowed from the original owner) comes out of the transaction whole, while the original owner (who is left at the end trying to redeem a worthless IOU backing massively diluted shares) is wiped out. Allowing someone to sell another person’s property, with no contractual obligation to make the owner whole, is simply fraud, even if it is legally sanctioned.

  • Chris Hossli

    what are some specific Islamic banks that allow Americans to open bank accounts online (if any)?

  • Jared Krauss

    Yes, I would like to know some specific banks overseas that allow American to open accounts online as well, not just Islamic banks, but from my studies here at college know the benefits of Islamic banking.

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