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Monday, 20 July 2009

Global recession and promises of Islamic finance

Dr. M. Mizanur Rahman

THE world economy is in the grip of a financial crisis. The crisis originated in the United States (US) with plunging house prices, stock price declines, and a severe credit crunch (falling credit availability), and then spread across Europe and major Asian countries. This financial crisis is far more serious than any experienced over the last four decades. International Monetary Fund (IMF) considers this financial crisis as more serious than the great depression of the 1930s. In spite of billions of dollars of bailout and liquidity injections by a number of developed countries, the crisis is showing no signs of abating. There is hence a call for a new architecture that would help minimise the frequency and severity of such crises in the future. But before we call a new architecture to redesign the financial market let us try to determine the primary cause of the financial crises.

Causes of present global crisis: It is very difficult to find out the causes of this financial crisis in one word but it is generally recognised that most important cause is excessive and imprudent lending by banks and financial institutions. There are several factors which make this possible for banks to resort to such unhealthy practice. Of them, the most important factor is the inadequate market discipline in the financial system resulting from the absence of profit and loss sharing (PLS). Mind-boggling expansion in the size of derivatives, especially credit default swaps (CDSs) is also an important factor as it claimed to provide protection to lenders against default. Another important factor is the “too big to fail” concept which tends to give an assurance to big banks that the central bank will definitely come to their rescue and not allow them to fail.

The false sense of immunity from losses introduces a fault line in the system. Banks do not, therefore, undertake a careful evaluation of the loan projects. This leads to an unhealthy expansion in the overall volume of credit, to excess leverage, and to an unsustainable rise to a steep decline in asset prices, and to financial frangibility and debt crisis, particularly if there is overindulgence in short sales. This can be justified by a comment “a bubble is more likely to develop when investors can leverage their positions by investing borrowed funds.”

The sub prime mortgage crisis in the grip of which the US finds itself at present, is also the result of excessive and imprudent lending. Securitisation of the “originate-to-distribute” model of financing has played a crucial role in this. Mortgage originators collateralised the debt by mixing prime and sub prime debt. By selling the collateralized debt obligations (CDOs), they passed the entire risk of default to the ultimate purchaser.

They had, therefore, less incentive to undertake careful underwriting. Consequently, loan volume gained greater priority over loan quality and the amount of lending to sub prime borrowers and speculators increased steeply. The lenders are not confident of repaying this excessive and imprudent lending which results and excessive resort to derivatives like credit default swaps (CDSs) to seek protection against default. The buyer of the swap (creditor) pays a premium to the seller (a huge fund) for the compensation he will receive in case the debtor defaults. If this protection had been confined to the actual creditor, there may not have been any problem. The problems arise when the hedge funds sold the swaps not to just the actual lending bank but also to a large number of others who were willing to bet on the default of the debtor. These swap holders, in turn resold the swaps to others. The whole process continued several times. While in genuine insurance contract only the one actually insured claims compensation, in the case of CDSs several swap holders will claim compensation. This accumulates the risk and makes it difficult for the hedge funds and banks to honour their commitments.

Although many Americans are blaming the Jewish lobby and Israel for the current catastrophic financial crisis affecting the USA and the world (Abrahamam Foxman, New York Times, October 7, 2008), there is still no proof that anyone can blame the global markets crisis on any one group nor can one blame it on any other country. Therefore, it may not be anything to do with religion or ethnic groups rather this global economic crisis driven by greed. But without making any debate of putting responsibilities on any body’s shoulder nor even blaming any religion or ethnic groups we will broadly discuss the feature of the financial system and will see if the Islamic financial system can be an alternative of the conventional financial system.

The Islamic financial system: Allah says in the Holy Qur’an that a society where there is no justice will ultimately head towards decline and destruction (Al-Qur’an 57:25) which implies that the most important objective of Islam is to realise greater justice in human society. Justice requires a set of rules or moral values, which everyone accepts and faithfully complies with. The financial system may be able to promote justice, if it satisfies at least two conditions based on moral values. One of these is that the financier should also share in the risk so as not to shift the entire burden of losses to the entrepreneur, and the other is that an equitable share of financial resources mobilised by financial institutions should become available to the poor to help eliminate poverty, expand employment and self-employment opportunities and, thus, help reduce inequalities of income and wealth.

To fulfill the condition of justice, Islam requires both the financier and the entrepreneur to equitably share the profit as well as the loss. For this purpose, one of the basic principles of Islamic finance is: No risk, no gain”. This should help motivate the financial institutions to assess the risk more carefully and to effectively monitor the use of funds by the borrowers. The double assessment of risk by both the financier and the entrepreneur should help inject greater caution into the financial system, and go a long way in reducing excessive lending. Islamic finance should, in its ideal form, help raise substantially the share of equity and profit-and -loss sharing (PLS) in business. Greater reliance on equity finance has supports even in mainstream economics. This is because all the financial needs of individuals, firms, or governments cannot be made amenable to equity and PLS. Debt is, therefore, indispensable, but should not be promoted for inessential and wasteful consumption and unproductive speculation. For this purpose, the Islamic financial system does not allow the creation of debt through direct lending and borrowing. It rather requires the creation of debt through the sale or lease of real assets by means of its sales- and lease-based modes of financing (murabaha, ijarah, salam, istisna and sukuk). The purpose is to enable an individual or firm to buy now the urgently needed real goods and services in conformity with his/her ability to make the payment later.

Prospects of Islamic Finance over Conventional Finance: The current financial turmoil has provided an opportunity for Islamic finance to position itself as a viable alternative to conventional finance by providing investors with other asset classes and markets that provide stability. Under current political crisis, there is much talk about the creation of a new international economic order. There is a growing consensus that the unregulated capitalism that has led us to this crisis needs to be reconfigured to provide greater resilience and stability to the financial system.

The strengths of Islamic finance are derived from shariah principles, which also happen to be sound business principles. The shariah injunctions require that financial transactions be accompanied by an underlying productive activity thus giving ride to a close link between financial and productive flows. The shariah principles prohibited excessive leverage and speculative financial activities thereby insulating the parties involved from too much risk exposure.

It is worth speculating to what extent the world financial crisis could have been averted, or at least its impact considerably reduced, if the principles of Islamic finance had been more widely practiced. There is now a greater awareness and interest among the world financial community about the merits of Islamic finance. Literature shows that there is already a growing demand for Islamic financial products in the global market, far exceeding their supply. In recent years we have witnessed a rapid expansion of the Islamic financial services industry. Today Islamic finance is fast becoming an accepted component of the global financial system.

Bangladesh’s direct involvement in the development of Islamic banking and finance has significantly transformed the financial landscape at both the national and international levels, making the country a leader in the Asian as well as international race to become a important Islamic financial centre.

It is observed that the vibrancy and dynamism of Bangladesh’s Islamic financial system today is reflecting in its continuous product innovation, diversity of Islamic financial institutions, as well as the availability of Islamic finance talent and expertise which demands the comprehensive regulatory and legal infrastructure in the country.

It can be hoped that the Islamic capital market in Bangladesh can function as well as offer a wide range of products such as shariah-compliant stocks, Islamic unit trust funds, Islamic exchange-traded funds, shariah-compliant real estate investment trusts, structured products and derivatives.

The country can offer sukuk bond which will be able to establish several industries and also develop a deep and liquid market. In this regard, we can follow the model of Malaysian sukuk market which is one of the world’s largest and most innovative sukuk market. For establishing the sukuk market, Bangladesh may have to liberalise its foreign exchange administration rules so that different foreign development banks and multinational corporations can join in growing the sukuk markets.

Conclusion: Therefore, from the above discussion it can be concluded that the Islamic financial system is capable of minimising the severity and frequency of financial crisis by getting rid of the major weakness of the conventional system. It introduces greater discipline into the financial system by requiring the financier to share in the risk. It links credit expansion to the real goods and services which the seller owns and possesses and the buyer wishes to take delivery of. It also requires the creditor to bear the risk of default by prohibiting the sale of debt, thereby ensuring that he evaluates the risk more carefully.

In addition, Islamic finance can also reduce the problem of subprime borrowers by providing credit to them at affordable terms. This will save the billions of bailout dollars spent for the crisis-ridden bank. This does not help the poor because their home may have already become subject to foreclosure and auctioned at a give-away price.

The problem is that Islamic finance has at present a very small share of global finance. However, it is the ability of the system to solve a problem that matters. If Muslims themselves establish the system genuinely and successfully with proper checks and controls, the whole world will ultimately come around to it and the financial sector of Bangladesh will also be benefited out of it.

The writer is an economist and researcher. He can be reached at Email:

Alfalah Consulting - Kuala Lumpur:
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Islamic Investment Malaysia:

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