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Saturday, 2 April 2011

Could Islamic finance have prevented the global economic crisis?

A question that is often discussed is: if the global economic crisis triggered by the housing bubble burst and the sub-prime credit crisis in the US would have been averted if the Islamic finance framework were in place. It is a question that is asked often and one that has generated global interest. The answer is that in principle, Islamic finance may have prevented the sub-prime crisis leading to the global economic crunch.

In my opinion, the very founding spirit of Islamic finance is anti-speculation and “anti-bubbles,” if you will. I would qualify that improper risk management and lack of execution of principles in any financial system conventional or Islamic can potentially lead to similar negative results. However, understanding the general concepts behind Islamic finance, one may begin to appreciate the positives of this form of banking that is one of the fastest growing in the world and stands at around $1 trillion.

Islamic finance prohibits usury or charging interest for the use of money (Riba in Arabic), investing in speculative financial products like certain derivatives and engaging in businesses, products and services that are considered forbidden (Haram) in Islam. Furthermore, Islamic banking emphasizes partnership (Musharakah) in profit and loss sharing, asset-backed investing and more importantly it is not restricted to Muslims. As a matter of fact several secular states including Singapore have seen an increase in demand for Islamic financial products. In essence under Islamic law (Shariah) one cannot lend money to make money or engage in predatory lending which leads to poor getting poorer and rich getting richer, i.e. exploitation is strictly forbidden. Also, debt cannot be taken on without collateral or an asset backing. One must refrain from gambling (Maisar) and uncertainty (Gharar), i.e. you cannot sell what you donĂ¢€™t own. Both buyer and seller are involved in the transaction with a no-pain, no-gain approach to making profits or sharing losses. This sounds common sense, ethical, trust-fostering and would appeal to most people.

Now lets examine what caused the sub-prime crisis. Coming out the dot-com bubble crash the central bank kept interest rates low in order to stimulate growth in the economy. So far so good. At low interest rates however banks started engaging in sub-prime lending with adjustable rate mortgages or ARMs. Simply put, you extend a house loan to someone with high credit risk at low interest rates but as the rates adjust upwards, which means the monthly mortgage payments shoot up the same high risk borrower becomes a “very high risk” borrower. While these loans were being issued innovation kicked in and several financial institutions repackaged the very same loans and sold them as “bundled” debt or MBS (Mortgage Backed Securities) to other investors. Rating agencies continued to rate these bundles of debt as relatively safe and high grade, which turned out not to be the case. To make this even worse based on these ratings many investors bought these securities and some also bought credit default swaps or CDS as insurance against these loan packages. On the other side insurance companies and other financials took on the credit default risk, i.e. if the loans went bad these insurance companies would pay for the shortfall. Recall these insurance companies were also relying on ratings agencies on the credit worthiness of the loans. With all of this playing out over several years leading up to 2006 as the markets started recovering from the dot-com bubble, interest rates now started going up. That in turn led to a trigger in sub-prime mortgage defaults, which in turn led to severe drop in MBS prices or the value of bundled loans, which further led to insurance companies having to pay for the shortfall. All of this led to freezing up of credit and money markets as capital was getting destroyed and investors just didn’t know how bad this could get. We saw markets collapse fairly quickly and while we have seen a global recovery since the 2007/2008 period. I am still not very convinced if we have fully averted the global crisis just yet. The US economy is still witnessing a jobless recovery for the most part with unemployment at 9.5% and the European Union crisis seems to have a revolving door, first with Greece and now with Ireland needing a bailout.

By no means should one assume that as an alternative, Islamic finance framework alone would be a 100% water-tight solution as the regulation and execution within the system is just as important as its underlying principles. However if we just examine the sub-prime crisis chain of events and the level of leverage and speculation not to mention lack of regulatory oversight, we may deduce that under Islamic finance principles much of the excess would have been “checked at the door” and not have come about at several times during the birth of the crisis. For example under Islamic banking regulations loans would not have been repackaged and traded as MBS and CDS would not be linked to these speculative products thus mitigating the chance for a ballooning effect. While Islamic finance continues to evolve rapidly the recent economic crisis has bought it some market share! In the end market decides the value of any goods and services and over last five years the Dow Jones Islamic Index is up 18% compared to the S&P 500 down 8%.

(By: Saud Masud....the CEO of SM Advisory Group, LLC. a consultancy firm focused on Middle East, North Africa and South Asia region)


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