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The Global Financial Crisis & Islamic Finance P.2

Islamic Finance and the Global Economic Crisis
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.
financial-growth
Islam encourages business and productive economic activities that generate fair and legitimate profit.

Part 1 - Part 2 - Part 3

Islamic Theory of Finance and the Global Financial Crisis

The current global financial crisis has accentuated the urgent need to embark on one of the most radical reshape of the international financial system.

The attitudes and the approaches articulated by the advocates and the opponents of both government intervention versus free market economies schools of thought thus far have failed to deliver a viable long-term solution to the crisis or to prescribe a practical mechanism on how to deal with its consequences and implications.

So, has the time come to seek out alternatives?

The 1988 Nobel Prize winner, French economist Maurice Allais has foreseen the inevitability of current structural global economic crisis and warned against its consequences. He categorically argued that the way out of such crises is best achieved through structural reforms that go far beyond addressing the symptoms of the crisis to devising an efficient monetary system that is truly capable of preventing such crisis from happening in the future. The two basic components at the heart of the proposed system are adjusting the rate of interest to 0% and revising the tax rate to about 2%.

Incidentally, these are the core elements of Islamic economics; Islam prohibits interest (riba) and requires all Muslims who possess minimum net worth above their basic needs (Nisab) to pay Zakah (2.5% of the assets that have been owned over a year). Zakah is a major economic instrument premeditated to spread socio-economic justice amongst Muslims.

Unsurprisingly, the US reserve has just announced the cut in lending rate to be between 0% and 0.0025% and the demand for meaningful tax cuts is building up.

The Potential of Islamic Finance as an Alternative Model for Global System

A host of Muslim scholars and practitioners strongly argue that Islamic finance “has the potential to become an alternative model for global system” (Understanding; Global; Islamic finance; Crisis; Islamic banks; The Global). Their arguments are based on the following pillars of the Islamic theory of finance.

Islamic Finance is a model that “is based on themes of Community Banking, Ethical and Socially Responsible Investments and Affinity Marketing” (Issues)

The most salient values of Islamic finance are fairness, socio-economic justice and its uncompromising commitment towards the well-being of future generations through the caring for the environment and preserving earth’s valuable resources. The philosophical reasoning underlying the principles of the Islamic financial system is the implementation of a financial system (wealth accumulation and wealth distribution) that is fair, just and unbiased towards the rich minority at the expense of the poor majority. The ultimate aim is to spread socio-economic justice amongst all people regardless of their whereabouts. The principles of Islamic finance advocate fairness in payoffs and reward structures and embrace socio-economic justice amongst all. Islam preaches “moderation” in all aspects of people’s lives, and commands them to live within their means.

Islam prohibits paying or receiving any predetermined fixed rate of return on borrowed/lent money.

Accordingly, Ibn Taymiyyah (d. 1328), a highly respected scholar, says: “Hence, justice towards everything and everyone is an imperative for everyone, and injustice is prohibited to everything and everyone. Injustice is absolutely not permissible irrespective of whether it is to a Muslim or a non-Muslim or even to an unjust person".

From the foregoing discussion of the causes of current financial crisis, the tenets of Islamic finance indicates how it has potential as a viable alternative global financial system. First, Shari’ah-compliant banking proposes uncompromising moral guidelines for dealing with money. Supply of money must be proportionate with the prospects of real growth in the economy in order to provide for a sustainable development and more equitable distribution of wealth. A host of intellectuals are forcefully arguing for the “return to some form of commodity (i.e., gold) currency peg” in order to reinstate value for money and streamline its supply.

The printing of trillions of dollars and other currencies without proper backing in an attempt to restore a sense of economic equilibrium will undoubtedly lead to a much higher inflation rate due to excessive liquidity, large deficits in fiscal and monetary policies and eventually drive interest rates to new heights, as central banks endeavor to restrain excessive spending (Gold; Healthy money; Manias; The future; The Return)

Second, all activities in Islamic finance are permitted (halal) except those, which have been specifically forbidden (haram) by Shari’ah due to their harmful and destructive implications. The most fundamental pillar of Islamic finance industry is the concept of Shari’ah-compliance, which dictates that the financial approach of Muslims should be governed by two major sets of rules.

Firstly, unlike in conventional finance, Muslims are strictly prohibited from investing in or dealing in economic activities that involve interest, uncertainty, and speculation, regardless of their form or shape or the pretexts that are often used to justify them.

Secondly, Muslims are discouraged and forbidden from investing in businesses that are illicit activities. This include production and distribution of goods and/or services that stand against the tenets of the Islamic value system such as alcohol beverages, pork-related products, drugs, gambling, conventional insurance, war profiteering and indecent entertainment.

Third, Islam prohibits paying or receiving any predetermined fixed rate of return on borrowed/lent money. Charging with interest (riba) tends to drive the poor into more poverty and create more wealth for the wealthy without doing work or sharing the risk involved in every business undertaking.

The interest further creates wealth without actually being the outcome of productive economic activity or as the result of an increase in commodity supply. Islam therefore considers all interest-based financial arrangements to be unfair, unjust and morally unjustifiable and all money generated by such transactions to be unearned money:

{And because of their much hindering from God’s way, and of their taking riba, though they were forbidden it; and of their devouring people’s wealth wrongfully. We have prepared for those among them who disbelieve a grievous punishment.} (An-Nisa’ 4: 161)

Interestingly, all major religions (Judaism, Christianity and Islam) and other ethical systems such as Buddhism and Hinduism were united in denouncing interest as unethical and immoral practice.

Fourth, money generated from “rent-seeking activity” such as charging interest creates new but artificial capital, which is by no means the life-blood of the markets. Ahmad Imad Ad-Dean pointed out: “The essence of the market is entrepreneurship” and explained that: “trade, not banking is the primary function of markets”. (Islam, Market, 51)

Islam encourages business and productive economic activities that generate fair and legitimate profit thus reinforcing the positive relationship between financial flow and productivity. “This intrinsic property of Islamic finance contributes towards insulating it from the potential risks resulting from excess leverage and speculative financial activities” (Global financial crisis)

Prophet Muhammad (peace be upon him) emphasized the significance of honesty, specifically in business dealings.

The outcomes of several empirical studies have highlighted the merit of interest free banking over interest based banking in relation to financial stability and economic efficiency (The Islamic interest; Future wealth, Transforming; Islamic law; Islamic finance). The current financial crisis saw trillions of dollars evaporate from the world economy. The extent of the financial meltdown has incited some Muslim scholars to construe such losses of virtual wealth as being God’s fulfilled promise that: {Allah will deprive usury of all blessing and will nourish deeds of charity}(Al-Baqarah 2: 276)

Fifth, in the absence of interest-based financial transactions under Islamic finance, financial relationships between financiers and borrowers are best understood within the framework of profit-and-loss sharing (PLS) contracts. The concept of PLS entails that when entering into a partnership (musharakah) contract, both parties share the risk (and returns) and have vested interest in seeing the partnership agreement come to a satisfactory ending.

Sixth, “Religious orientations aside all those who care about the ethical content of their financial transactions are likely to be inclined towards Islamic finance in that there is much more to Islamic finance than the mere elimination of riba” (Islamic banking, 119-20; Islamic Financial)

Social responsibility, sustainability and morality in business are emerging issues that are increasingly attracting the interest of scholars, politicians, economists, social activists, as well as investors.

Interestingly, while these issues are now topics of debate in the West, they are embedded within the Islamic ethical code of conduct and are considered fundamental tenets for devout Muslims.

The rules of Shari’ah unconditionally prohibit Muslims from taking part in any transaction that might involve fraudulent, dishonesty, exploitation, and ambiguity: {Woe to those that deal in Fraud} (Al-Mutaffifin 83: 1)

Prophet Muhammad (peace be upon him) emphasized the significance of honesty, specifically in business dealings. He said:

"If anyone sells a defective article without drawing attention to it, he/she remains under Allah’s anger." (Ibn Majah)

These noble values are treasured and shared by many Muslims as well as non-Muslims who insist in investing in social responsible portfolios despite the fact that such investment might have a lower rate of return. Therefore, it would be fair and sensible to claim that each and every financial activity that complies with the Shari’ah rules and guidelines is a socially responsible activity.

Seventh, Islamic financial institutions, in providing interest-free financial services and investment opportunities, are under religious and moral obligations to assume leading developmental role in promoting productivity and entrepreneurship. Sallah rightly argued: “Being an Islamic institution with responsible mission, the [Islamic] bank must act with more developmental orientation.” (Islamic financial, 128)

While the prevailing objective of conventional banks in a capitalist market economy is maximizing profit by unjustly charging optimal interest rate, Islamic Financial Institutions are expected to demonstrate their true spirit and prove their viability as partners in development rather than instruments of exploitation.

Finally, the principle of “no pain no gain‟ embedded in the Islamic financial structure entails that no one has the right to rewards (profit) if they do not equally share the risk of incurring loss.

Omer Chapra believes that this concept “should help introduce greater discipline into the financial system” (The global financial). Realizing the affirmative linkage between sharing the profit and sharing the risk involved in any business transaction undoubtedly would motivate financial institutions to adopt a more cautious approach to lending and careful underwriting practices.

Being a partner, rather than merely a lender, compels the financier (lending institution) to assess risks more carefully and to effectively monitor the use of funds by the entrepreneurs (borrower). The double assessment of risks by both the financier and the entrepreneur “should help inject greater discipline into the system” and restrain excessive lending and borrowing as well.

Could Islamic Finance Withstand These Shocks?

The aftermath of the global financial crisis did not leave Islamic finance unscathed. The eventual emergence of global recession has affected Islamic Financial Institutions. To cite a few examples “AMLAK”, the Dubai based Islamic mortgage provider, is in financial woes and Investment Dar of Kuwait has defaulted on its sukuk (Islamic financial certificate) obligations. Retail Islamic banks have encouraged consumer indebtedness.

Islamic finance is based on equity capital rather than debt. Lending transactions are based on the concept of assets backing.

However, Islamic Finance remained relatively positive and resilient despite the gloom and volatility of the prevailing global financial environment. It has been strongly argued that if global banking practices adhere to the principles of Islamic finance (entrepreneurship and transparency), then, the global crisis, would have been prevented or the impact significantly curtailed. This argument is built on the fact that most, if not all, the factors that have caused or contributed to the development and the spread of the current global financial crisis are not allowed under the rules and guidance of Shari’ah. (Figure 1)

Theoretically, it would be impossible for a crisis resulting from subprime mortgage, inadequate assessment of risk, complex financial instruments to shift risk, speculation and short selling, excessive leverage, lax regulatory framework and excessive lending among others, to take place in the Islamic capital markets sector for the following reasons. First, it is against Shari’ah principles to sell a debt against a debt. There is a very simple but fundamental rule in Islamic trade, one can’t sell or lease unless he/she posses real assets.

As Islamic finance prohibits the pure sale of debt and risky speculative financial business transactions, it demands that financial transactions be consistent with "fair play", justice and transparency. All parties to a contract are required and entitled to a full disclosure of the pros and cons of the business transaction in order to have a better assessment of the risk involved.

Second, Islamic finance is based on equity capital rather than debt. Lending transactions are based on the concept of assets backing. Consequently mortgage loans under such system would have been backed by solid asset structure that safeguards the banking industry against possible loan defaults. The enormity of loan defaults, should they occur within Islamic financial setting, will in no way threaten or compromise the health and proper functioning of the banking system. In the present crisis, trillions of dollars have been trading without backing of assets. One can strongly argue that the current financial crisis would have been prevented if such transactions were conducted in conformity with the Islamic finance model, where “virtual money” has no place in its accounting books.

Islam preaches “moderation‟ in all aspects of Muslims’ lives, and commands Muslims to live within their means. Therefore the majority of Muslims would not have rushed to draw loans that they are in no position to repay – just because an opportunity has arisen.

Third, Islam takes particular interest in fostering close relationship and trust between originators (financial institutions) of Islamic financial products and investors. This honest relationship suggests that a high level of transparency will be shared between the parties involved in a business transaction. Investors therefore will be compelled to open up to their financiers, who in turn will be inclined to authorize loans only to worthy borrowers based on genuine need and identifiable business activity.

The significance of nurturing positive relationships between the financier and the investor is gaining wide acceptance in Islamic as well as non-Islamic financial landscapes. In an astounding move, the Vatican has recognized the implication of bringing banks closer to their clients and accredited Islamic finance for being the frontrunner in this regard. The Vatican urged conventional banks to consider the ethical rules of Islamic finance “to restore confidence amongst their clients at a time of global economic crisis” (Vatican)

chart_1

Fourth, another major factor that contributed to the current financial crisis is the absence of an adequate and effective regulatory control system that monitors and consequently ensures the interests of investors. The Islamic regulatory control system stipulates that potential investors and all stakeholders are cognizant of opportunities and risk in the business contracts. Risk must be explicitly communicated to all stakeholders, and financial institutions are under obligation to conform to comprehensive disclosure and transparency standards.

Fifth, an honest implementation of Profit-and-Loss Sharing (PLS) transactions (such as Mudarabah and Musharakah contracts) in accordance with the spirit of Shari’ah entails full disclosure and transparency. Full disclosure and transparency will definitely work toward enhancing the prospective for market discipline by providing built-in mechanism which serves to control imprudent lending and ensure financial stability of the Islamic financial system. Mudarabah and Musharakah are also seen as effective instruments for managing risk, where partners tend to take a balanced approach towards business transactions by weighing the prospects of gain against the risk of loss. This avoids speculations and preventable uncertainty (gharar).

Sixth, to prevent subprime lending, Islam regards the relationship between the lender (financial institution) and the borrower (investor) as a partnership, wherein the lender has a continued stake in the transaction. Default risk cannot be shifted or sold off. Both lenders and borrowers have mutual interest in the transaction and “subprime" deals are highly unlikely to occur. Siddiqi strongly argues that “risk shifting is gambling” (Current) and further explains that each and every loan made by a lending institution is subject to credit risk. Banks sought to protect themselves against risk of default by selling these risks to a third party in a zero sum game. Unlike PLS contracts where both parties are exposed to gain and loss, risk shifting assures only one party (seller of the risk or the buyer) gain the losses incurred by the other parties without the creation of additional wealth.

Seventh, in the wake of the many corporate failures due to unethical accounting and business practices, investor trust has been eroded. Islamic finance provides a moral and practical option for those keen in investing in socially responsible and ethical investment portfolios. One can justly argue that fraud, corruption and greed are not limited to non Muslims. Muslims as well are engaged in such unethical practices. But what differentiates the ethical boundaries of Islamic finance is that ethics are entrenched in Islamic institutions.

The concept of ethics in Islam gains its legitimacy from divine commands that establish operational guidelines, which permeate all spheres of Muslim life. The western business ethics are neither based on, nor sanctioned by, an accepted source of ethical ideals (supreme religious might). They also lack authority and the power of generalization because they are man-made guiding principle, based on trial-and-error.

Consequently, they are limited to their respective environments at certain point(s) in time.

Chart 2 links key principles of Islamic finance to “market failures‟ and suggests that the likelihood of market failure will be significantly reduced, if not eliminated, when these principles are adhered to and put into practice in all financial transactions.

Islamic finance principleIntuitive description Linkage to ‘market failures’?
1. Riba prohibited"Earning money from money" or interest, is prohibited. Profit, which is created when "money" is transformed into capital via effort, is allowed. However, some forms of debt are permitted where these are linked to "real transactions", and where this is not used for purely speculative purposesA real return for real effort is emphasised (investments cannot be "too safe"), while speculation is discouraged (investments cannot be "too risky"). This might have productive efficiency spillover benefits ("positive externalities") for the economy through linking returns to real entrepreneurial effort
2. Fair profit sharingSymmetric profit-sharing (eg. Musharakah) is the preferred contract form, providing effort incentives for the manager of the venture, while both the investor and management have a fair share in the venture's realised profit (or loss)Aligning the management's incentives with those of the investor may (in contrast to pure debt financing) once again have productive efficiency spillover benefits for the economy, through linking realisable returns to real entrepreneurial effort
3. No undue ambiguity or uncertaintyThis principle aims to eliminate activities or contracts that are gharar, by eliminating exposure of either party to excessive risk. Thus the investor and manager must be transparent in writing the contract, must take steps to mitigate controllable risk, and avoid speculative activities with high levels of uncontrollable riskThis may limit the extent to which there are imperfect and asymmetric information problems as part of a profit-sharing arrangement. Informational problems might, for example, provide the conditions for opportunistic behaviour by the venture (moral hazard), undermining investment in all similar ventures in the first instance.
4. Halal vs. haram sectorsInvesting in certain haram sectors is prohibited (eg, alcohol, armaments, pork, pornography, and tobacco) since they are considered to cause individual and/or collective harm.Arguably, in certain sectors, there are negative effects for society that the investor or venture might not otherwise take into account (negative externalities). Prohibiting investment in these sectors might limit these externalities

It is evident from the above that many assumptions have been made, most notably that Muslims always practice Islam and abide by its teachings in financial activities and daily life. The merit of this assumption is largely questioned and contested. Muslims’ actions are not always in harmony with the ideals they preach. One of the compelling evidence is the authenticity when applying Murabaha contracts in Islamic finance.

Works Cited

Aglionby, John. Islamic banks urged to show the way. Financial Times. Last access September 10, 2012

Ahmad, Imad Ad-Dean. "Islam, Market Economy, and the Rule of Law," (Second International Symposium on Liberalism in Ankara 18-19 May 1996)

Ayub, Muhammad. Understanding Islamic Finance. USA: John Wiley & Sons Ltd., 2007

Chapra, Umer. The Global Financial Crisis: Can Islamic Finance Help? Japan: KIAS, 2009

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…,. Transforming Economic Life: A Millennial Challenge. Devon: Green Books, 1998

Sallah, Ramadan. Jordan: The experience of the Jordanian Islamic bank. In R. Wilson ed., Islamic financial markets. New York: Routledge, 1990

Siddiqi, Muhammad, Nejatullah. (31 October 2008). “Current Financial Crisis and Islamic Economics”. siddiqi.com. Last access, September 12, 2012

Totaro, L. (2009). Vatican says Islamic finance may help Western banks in crisis. Retrieved 26 March 2009 from: www.bloomberg.com/apps/news

Vadillo, U. The Return of the Islamic Gold Dinar. Kuala Lumpur: Madinah Press, 2002

Vandore, Emma. (2008). “Crisis Widens Appeal of Islamic Banking”. AP Business Writer. Global Islamic finance . Last access, Wednesday 12, 2012

Venardos, Angelo, M. Islamic banking and finance in South-East Asia: Its development and future. Singapore: World Scientific Publishing Co. Pte. Ltd, 2005

Vogel, Frank and Hayes, Stephen. Islamic Law and Finance: Religion, Risk, and Return. Berlin: Springer, 1989

(... 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:
Prophet Muhammad and Justice
Islam and Economics
Social Solidarity & Social Justice in Islam
Islamic Economics: An Alternative?
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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