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The Global Financial Crisis & Islamic Finance P.1

Islamic Finance and the Global Economic Crisis
The Financial Crisis & the Islamic Finance Renaissance
The conventional view holds that the current global financial crisis was caused by extraordinarily high liquidity, reckless lending practices, and rapid pace of financial engineering which created complex and opaque financial instruments used for risk transfer. There was break down of lender-borrower relationship, informational problems caused by lack of transparency in asset market prices, particularly in the market for structured credit instruments. The current global financial crisis is largely seen as a real test of the resilience of the Islamic financial services industry and its ability to present itself as a more reliable alternative to the conventional financial system. This paper will tackle the causes of the global current financial crisis; the Islamic theory of finance and solutions to the current crisis; managerial implications of Islamic finance.
economic crisis
Financial bubbles are generally linked to easy credit, excessive debt, speculation, greed, fraud, and corruption.
Finance

Part 1 - Part 2 - Part 3

Introduction

Despite being an evolving industry, Islamic finance has enjoyed a steady and consistent horizontal as well as the vertical growth since the concept was put into practice some 40 years ago. Being able to endure the implications of the global financial crisis and remain relatively positive in the midst of the crisis and eventually to emerge as more equitable and efficient system have raised the profile of Islamic finance and underscored its capacity to bring stability to the global financial system.

There is a general agreement amongst economists, financial scholars and financial experts about the causes and the consequences of the global financial crisis. However, the search for "the solution" to the crisis thus far has proved to be "mission impossible", and remains the subject of an interminable debate.

Should governments intervene in markets or should the solution be left “for the market to find a solution”? Government bailouts of existing banking system neither present a long term solution to the problem nor give assurance that similar crisis will not happen in the future. On the other hand, the current global financial crisis has invalidated the argument promoted by free market advocates that “markets are efficient on their own” and market forces are capable of managing and correcting market inefficiencies should they arise.

World economies are yet to devise prudent strategies on how to deal with the crisis, let alone to recuperate and overcome its vindictive aftermath. The endeavor in this paper therefore is to extend the search for an alternative that is potentially capable of limiting, if not eliminating, the sources of such crisis, and bringing stability to the market.

Carrying out systemic analysis of the causes of the crisis and measuring these causes against the intrinsic principles of the Islamic financial system reveals that such crisis could have been prevented if Islamic financial principles were prevalent. The paper concludes that along with the enormous challenges that the crisis has created to the conventional financial system, it has presented the IFSI (Islamic Financial Services Industry) with abundance of opportunities to demonstrate its relevance.

The paper is divided into five sections. Following introduction in Section 1, Section 2 discusses the causes of the global current financial crisis. Section 3 examines the Islamic theory of finance and how it can or cannot provide a solution to the current crisis. Section 4 provides a critical analysis of what lies ahead for Islamic finance and managerial implications of Islamic finance.

Financial Crisis

“Financial crisis” broadly refers to disruptions in financial markets causing constraint to the flow of credit to families and businesses and consequently having adverse effect on the real economy of goods and services. The term is generally used to describe a variety of situations in which investors unexpectedly lose substantial amount of their investments, and financial institutions suddenly lose significant proportion of their value.

Financial crisis include, among others, stock market crashes, financial bubbles, currency crisis, and sovereign defaults.

Causes and Consequences of Financial Crisis

Financial bubbles are generally linked to easy credit, excessive debt, speculation, greed, fraud, and corruption. Easy credit leads to lack of adequate market discipline, which in turn instigates excessive and imprudent lending. Chart 1 below presents a summary of the most frequently cited factors as being potential contributors to financial crisis.

Chart 1:

Causes of financial crisis 

DescriptionRisk/Consequence
LeverageBorrowing to finance investmentBubble that leads to bankruptcy
Asset-liability mismatchThe disparity between a bank’s deposits and its long term assets leads to the inability of banks to renew short term debt they used to finance long term investments in mortgage securitiesBank runs
Regulatory failure

Improper (insufficient/excessive) regulatory control:

-Insufficient regulation:

1) Results in failure of making institutions' financial situation publicly known (lack of transparency)

2) Makes it possible for financial institutions to operate without having sufficient assets to meet their contractual obligations. 

- Excessive regulations that require banks to increase their capital when risks rise leading to substantial decrease in lending when capital is in short supply.

-Excessive risk-taking -Financial crisis (of 2008)

 

 

 

- Potential deterioration of financial crisis

Fraud, corruption and greed

Enticing depositors through misleading claims about their investment strategies and manipulating information.

- Creating financial assets without any real economic activity

- Extreme economic greed overrides basic ethical consideration in investments.

ContagionWhere the failure of one particular financial institution to meet its financial obligations (due to lack of liquidity, bad loans or a sudden withdrawal of savings) causes other financial institutions to be unable to meet their financial obligations when due. Such a failure may cause damage to many other institutions and threatens the stability of financial marketsSystemic risk
Money supplyUncontrolled printing of paper money that is not backed by real assist/commodity (gold)Higher inflation

Although it is difficult/impractical to single out one factor as being the source of financial crisis, one can rightly argue that the main cause of the financial crisis is attributed to a laxity of lending standards often adopted by conventional financial institutions – driven by greed and appetite for higher returns, and facilitated by the absence of adequate and appropriate government regulatory control. This easy approach to lending when practiced over an extended period of time leads to excessive and, in all probabilities, risky lending environment that eventually works against the interests of both borrowers and lenders alike.

It is believed that every economic crisis is the product of cheap credit

Why commercial banks tend to act in such inattentive manner and overstretch their lending norms despite their full awareness of the higher risk involved and the damaging consequences of such practices? The Muslim economist Omer Chapra explains the motives of banks for embarking on excessive and imprudent lending by three factors:

a) Lack of profit and loss sharing (PLS) between lenders and borrowers leading to inadequate discipline in the financial system;

b) Astronomical expansion in the size of derivatives particularly credit default swaps (CDS);

c) “Too big to fall” attitude of big banks which grant them assurance that the central bank will bail them out in crisis to forestall their collapse.

The decade preceding the current financial crisis was characterized by high volumes of loans, high loan arrangement fees, flexible short-term lending to increase chances of new mortgage and arrangement fees, and punitive exit fees when borrowers wanted to change their mortgage providers before the lapse of maturity period.

The substantial profits were used to pay bonuses to loan underwriters and their bosses. This was exacerbated by securitization of mortgages where loans were bundled up and sold to Freddie Mac (the Federal Home Mortgage Corporation) and Fannie Mae (The Federal National Mortgage Association). The banks could then free up their capital and increase the mortgage turnover and earn more selling fees. Banks became short-term lenders, broke long-term relationship with borrowers and ultimately adopted reckless lending. This reckless lending was the primary cause of the current financial crisis. For example Northern Rock bank of UK could lend 125% of the value of the property to enable the borrower to furnish and equip the house but the hide-sight was to earn high arrangement fees from high volume of the mortgage.

To this end, reckless lending culminated into two practices that precipitated the crisis; the use of exotic and complex financial instruments and over-reliance on financial models.

According to Laldin and Mokhtar, there are various ways of managing risk among them risk shifting/transfer, risk retention, risk avoidance and risk reduction. Credit derivative instruments such as credit default swaps (CDS) and collateralized debt obligations (CDO) focus on risk transfer.

Secondly over-reliance on financial models made risk quantification easy but lead to illusion of precision, flawlessness and a false sense of security among top managers and regulators. The value at risk model (VaR), which measures the maximum loss a firm may suffer on daily basis, was widely and blindly used to the extent that the Securities and Exchange Commission (SEC) required all financial institutions to disclose their risks to investors using VaR in the absence of any other model that could summarize all the risks the institutions faced. (Laldin and Mokhtar, 2009).

Financial markets have been driven by greed that has torn down the world’s financial system.

The diffident response of various Western governments and in particular the US government to the irresponsible practices of larger financial institutions has reinforced their “false sense of immunity from losses” (Chapra, 2009). The US government for instance has rushed to the rescue and announced its intention to buy toxic bank assets worth in excess of US$1 trillion, thus not allowing the collapse of troubled financial institutions.

The Subprime Mortgage Dilemma and the Current Global Financial Crisis

It is believed that every economic crisis is the product of cheap credit; low interest rates create demand for loans that cannot be repaid when interest rates subsequently rise. Lower interest rates in the United States meant that mortgages became more affordable and in more demand.

Banks, driven by sense of invulnerability and the desire to capitalize on existing opportunities to maximize their returns, adopted an easy approach to lending in order to have a bigger slice of the pie by selling more loans, thus making more money in fees and commissions.

Omer Chapra points out that in such an environment “loan volume gained greater priority over loan quality” and ordinary investors were enticed to live beyond their means. But as interest rates began to rise, new home affordability and the ability to repay existing loans have sharply plummeted.

The problem was exasperated by the questionable tactics adopted by mortgage brokers who opted to sell their customers on subprime loans, and further by the complexity of products that have been created by intermediary players that sought to pass the entire risk of default to the final purchasers.

There are several factors that have contributed directly or indirectly to the occurrence and the spread of the current credit crisis triggered by the US subprime mortgage calamities and the fallout of some US financial institutions. Derivatives and excessive leveraging of US financial institutions have driven some renowned financial institutions into bankruptcies and brought others to the edge of collapse. Financial globalization has duly played a key role in enabling hasty transfer of systemic risk within and across national boundaries.

Financial markets have been driven by greed that has torn down the world’s financial system.

Good and poor quality mortgages were bundled together in securitized packages

Speculation has reached intolerable levels. The intense competition and shareholders demands for higher returns have encouraged excessive risk taking and lured banks to extend their credit to unworthy borrowers who normally do not qualify for loans under prime lending criteria. In many cases loans were approved without proper evaluation of loan applications or the credibility of the applicants. The nature and the means of delivery of the interest and debt-based conventional banking have caused the financial system to be completely “split-off from the real economy”.

Deals and transactions have been concluded and executed on papers, and what have been sold and bought was of no real or economic value (Spiegel online, 2008). Poor enforcement of inadequate regulatory systems and lax on lending standards (easy credit) made it easy for lenders to sign-off as many loans and for borrowers to access loans that were considered beyond their reach without giving serious thought to the possibility of having to default on their loans.

Wilson (2009b) argues that the existence of the sub-prime borrowers was also a major cause of financial crisis. Sub-prime borrowers are characterized by default on mortgage obligations, previous credit, low income hence inability to repay substantial mortgages and insufficient coverage of health insurance. Moralists have questioned the finance rationality of high return concept, which justified charging high interest rate to low income sub-prime borrowers and low rate to high income, rich credit worth borrowers.

Good and poor quality mortgages were bundled together in securitized packages that were deemed able to endure an economic downturn. These mortgage-backed securities were sold to secondary investors and traded in the intermediary market, generating massive earnings for lending institutions and key staff and directors in the form of fees and bonuses. By having more cash in hand, banks were able to extend new loans and thus make more money. The model worked well while borrowers were making their payments. But when payments stopped, the model, literally, caved in.

The complex instruments formed a new financial structure that created risks which was not only difficult to understand but also thorny to assess. Some specific risks arising in the new financial structure are: (i) lax RM practices; (ii) under-pricing of risk; (iii) leverage/under capitalization; (iv) risk transfer; (v) creation of new risk; (vi) difficulty in assessing risk; (vii) breakdown of relationship between lender and borrower; (viii) excessive risk taking at the originator level and (ix) no control over underlying asset (Ahmed, 2009). The Bank of International Settlement (BIS) gave latitude to big financial institutions to craft and internalize VaR to measure the capital they needed to hold. VaR was institutionalized, albeit riddled with limitations discussed above. (Laldin and Mokhtar, 2009)

Alexander (2008) rightly concluded that the blame for the current financial crisis falls on the following three distinct entities:

1- Lenders and investment institutions for their impatience to sign off loans on “giveaway terms‟ and their (deliberate) failure to ensure the creditworthiness of loan applicants;

2- Government for lack of adequate and effective regulation evidenced by its oversight and indifferent attitude when such deceptive loans were made; and

3- Borrowers who solicited the loans despite their awareness of the potential failure to meet such financial commitments.

What began as a limited subprime mortgage impasse in the US real estate market grew to be the world’s biggest financial crisis since the 1930s.

The common view held by majority of Islamic financial scholars and practitioners is that the global financial crisis in reality is a crisis of failed morality (Siddiqi, 2008). Failed morality, arguably, is the product and the cause of greed, exploitation and corruption. This ethical failure is coupled with a failure in the relationship between investment originators and investors (Loundy, 2008). It is evident that originators of subprime loans have deliberately failed to communicate potential risks involved in these transactions with the investors (borrowers).

In summary, the widely held view is that the 2007/2008 financial crisis was caused by, among other factors, excessive liquidity in the market, financial engineering which culminated in multifaceted and difficult-to-understand financial instruments, informational asymmetry regarding in asset market prices, particularly in the market for structured credit instruments, archaic and liberal regulatory and supervisory oversight which spurred excessive risk taking and flawed accounting and risk management  models. The complicit coalition of players such as real estate developers and appraisers, insurance companies, credit rating agencies and various financial institutions led to a calculated under pricing of risk and creation of incentive structure that killed the traditional role of financial intermediation.

To mitigate the potential for re-emergence of similar financial crisis in future, there is need to reduce excessive risk taking through efficient regulation and supervision, increased capitalization of all players in the financial system to reduce leverage, increased focus on systemic rather than idiosyncratic risk, higher standard of proper and detailed disclosure of information by financial institutions on assets and instruments, proper mechanisms not only  to avert liquidity risk but also establishment of a trust or fund to buy distressed assets of market players to improve their liquidity, development of incentive structure that ensures that the total risk associated with off-balance sheet items is accounted for and development of accounting rules that would avoid a decline of asset prices and negative bubbles through the feedback loop in the financial system. (Mirakhor & Krichene, 2009)

Implications of the Global Financial Crisis

What began as a limited subprime mortgage impasse in the US real estate market grew to be the world’s biggest financial crisis since the 1930s. The impact of the crisis was felt worldwide.

Individuals, regardless of their whereabouts, have been directly or indirectly affected by the crisis as it has hit almost every sector of the world’s economy. World economies at large are yet to devise prudent strategies on how to deal with the crisis, let alone to recuperate and overcome its harsh reality.

Needless to say that conventional financial institutions, by and large, were the first to feel the full impact of the crisis that they have initiated. The 2008-year was packed of unparalleled events, which have created mass uncertainty, such as:

- Sharp decline in global equity markets

- The failure or collapse of numerous global financial institutions

- Governments of a number of industrialized countries allocated in excess of $7 trillion bailout and liquidity injections to revive their economies

- Commodity and oil prices reached record highs followed by a slump

- Central banks reduced interest rates in coordinated efforts to increase liquidity and avoid recession and to restore some (confidence) in the financial markets.

The financial sector gloom is most evident by the many (forced) CEOs resignations, mass losses and many bankruptcies of what, up to recent times, were considered world-class financial institutions such as HSBC, Merrill, Citigroup, AIG and Lehman Brothers. The setbacks of Dow Jones, NASDAQ, P&P, TSE, FTSE, NIKKE and many other European and Asian markets are factual indicators to the severity of the crisis.

When Lehman Brothers Holdings Inc.’s (LEH) filed for bankruptcy in September 2008, its property assets alone were valued at $43 billion, making it one of the largest bankruptcies in the real estate history. The unprecedented $180 billion government bailout of the insurance giant American International Group (AIG) apparently was not good enough to rid the insurance conglomerate from its troubles. Oil prices reached levels beyond the imaginations of oil exporting as well as oil importing countries alike before retreating to $35- $40. Yet nobody can really offer any explanation as to why oil prices rose and fell except for maybe them being based on pure speculative markets!

Economists, financial experts and politicians as well do not foresee a near end to the crisis and warn of prolonged hard times to come as the world’s major economies are heading towards recessions. The conjecture is that volatility and uncertainty in global financial markets are likely to linger causing more unemployment and a downturn in growth.

(... To be continued In-Shaa-Allah ...)

Source: Statistical, Economic and Social Research and Training Center for Islamic Countries (SESRIC) - http://www.sesric.org
Related Links:
Why Is There So Much Injustice in the World? (P.4)
Zakah and Achieving Socio-Economic Justice
How Did Prophet Muhammad Treat Non-Muslims?
Taking Care of Things at Home
Islamic Economy & Social Justice (Folder)

M. Kabir Hassan: Department of Economics and Finance, University of New Orleans, New Orleans, Louisiana, USA

Rasem Kayed: Department of Management, Arab American University, Jenin, Palestine

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