Islamic finance for a global solution
Saturday, 1 August 2009
Rasem N. Kayed and M. Kabir Hassan
THE economic crisis, which grew in the US out of cheap credit, gradually engulfed the world. Low interest rates created demand for loans which the borrowers could not repay. Such rates in the United States made mortgages more affordable. The banks, driven by a sense of invulnerability and the desire to maximise their returns, adopted an easy approach to lending to make more money in fees and commissions. In such an environment, "loan volume gained greater priority over loan quality." 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 sharply plummeted. The problem was aggravated by the questionable tactics adopted by mortgage brokers who opted to sell to customers subprime loans. Intermediary players sought to pass the entire risk of default to the final purchasers to further complicate the situation.
Several factors contributed directly or indirectly to what became a global crisis triggered by the US subprime mortgage calamity and the subsequent collapse of the US financial institutions. Derivatives and excessive leveraging of US financial institutions drove global financial institutions into bankruptcies and brought others to the edge of collapse. Financial globalisation played a key role in enabling hasty transfer of systemic risk within and across national boundaries.
The financial crisis, driven by greed and speculation, tore down the world's financial system. An intense competition for higher returns encouraged excessive risk taking and lured banks to extend credit to unworthy borrowers who normally do not qualify for loans under prime lending criteria. 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 concluded and executed on papers, were sold and bought, though they had no economic value. Poor and inadequate regulation and lax lending standards made it easy for lenders to sign-off loans. Borrowers accessed loans beyond their capacity to repay.
Good and poor quality mortgages were packaged together and the mortgage-backed securities were sold to secondary investors in the intermediary market, generating massive earnings for the lending institutions and key staff and directors in the form of fees and bonuses. The extra cash allowed the banks to extend new loans to make more money. The model worked well so long the borrowers were repaying. But when the borrowers could no more repay, the system callapsed.
The financial crisis was caused by an impatience of lenders to sign-off loans on 'give-away terms' and their deliberate failure to ensure the creditworthiness of the borrowers, the failure of the regulators to regulate the market, and of the borrowers to take loans they cannot repay.
Not only Islamic financial scholars but also western economists consider the global financial crisis, a crisis of failed morality, caused by greed, exploitation and corruption. It is evident that originators of subprime loans deliberately failed to communicate potential risks involved in these transactions to the borrowers or investors.
What began as a limited subprime mortgage crisis in the US real estate market grew to be the world's biggest financial crisis since the 1930s. The impact of the crisis continues to be felt worldwide. Individuals have been directly or indirectly affected by the crisis as it hit almost every sector of the world's economy. World economies are yet to devise strategies on how to deal with the crisis.
The conventional financial institutions, by and large, were the first to feel the impact of the crisis they had initiated. The unparalleled events of 2008 created mass uncertainty, a sharp decline in global equity markets, the collapse of global financial institutions, the governments in industrialised countries came out with massive bail-out funds to revive their economies and commodity and oil prices sky rocketted and later slumped. The central banks cut lending rates to increase liquidity in vain effort to ward off recession.
The financial sector gloom forced Chief Executive Officers (CEOs) to resign as bankruptcy gripped world-class financial institutions like HSBC, Merrill, Citigroup, AIG and Lehman Brothers. The collapse of American, European and Asian security made even the wealthy overnight paupers.
Lehman Brothers Holdings (LEH) filed for bankruptcy in September 2008, when its assets were valued at $43 billion, making it one of the largest bankruptcies in the real estate history. An unprecedented $180 billion government bail-out for the American International Group (AIG) apparently proved not good enough to rescue the insurance giant. Oil prices reached levels beyond the imaginations of oil exporting as well as oil importing countries alike. Yet nobody could offer any explanation as to why oil prices rose and fell like this.
Economists, financial experts and politicians alike do not expect the crisis to end any time soon. They all warn that the hard times could prolong as the world's major economies continue to sink deep into recession
In this context, it is relevant to examine the immediate impact of the crisis on Islamic banking and the potential of Islamic banking to solve it. The direct impact of the crisis on the Islamic banking system was minimal due in part to the intrinsic principles followed by it.
Emmanuel Volland, analyst with the rating agency, Standard and Poor's, explains that "Islamic banks were not caught by toxic assets as Shariah law prohibits interest". Furthermore, the lack of structured products and the reluctance of Islamic banks to exploit sophisticated financial instruments enabled these banks to stay off the crises. Praising the cautious approach adopted by Islamic banking, Amr al-Faisal, a board member of Dar al-Mal al-Islami, commented, "We are more conservative and sober in our investments. What used to be considered a handicap is now "considered the height of wisdom". In fact, successful banks have always been "conservative lenders".
Although Islamic finance has not felt 'the full impact' of the global credit crisis, the immediate fallout from the crisis is evidenced by the fall in equity valuations and the plunge in the real estate market across the Gulf States with all that entails for the Islamic banking system. Lending under Islamic law is based on the concept of asset backing, where real estate is the preferred instrument to protect these investments. According to Standard and Poor's (S&P), the Islamic financial sector also has suffered a sharp decrease in the value of sukuk (Islamic financial certificate, similar to a bond in Western finance, complies with Shariah) issued in the year 2008 to the tune of $14.9 billion, down from $30.8 billion in 2007. Malaysia led in Islamic finance in 2009. Moreover, uncertainties in the global financial markets are, by and large, adversely impacting on the Islamic financial industry.
As to the long-term implications, Standard and Poor's believes that while the immediate future for Islamic financial institutions was uncertain, they have strong long-term prospects. The resilience of Islamic banking and its ability to navigate to safe shores depend largely on the competence of the human capital in charge of Islamic banking and its sincerity in reflecting and integrating the ethos of Islamic teachings into all aspects of the financial industry. The shortcomings of the Islamic financial system are most likely to prevent it from assuming a leading role in the international financial market. "The system is still in its infancy" and "not fully prepared at present time to play a significant role in ensuring the health and stability of the international financial system". Islamic banks need to diversify their funding sources beyond retail deposits and further develop and diversify new and existing products such as Islamic hedging, derivatives, liquidity and risk-management instruments. The Islamic financial system is on the right track and is expected to sustain steady growth and progressively establish itself as an influential and constructive key player in the international financial market.
According to a different reading, which the "immaturity of the Islamic financial industry has, in part, saved it from a subprime-like mess so far," "what will save it when the industry grows up?" they ask.
The west's search for 'the solution' to the crisis thus far proved to be 'mission impossible'. Should governments intervene in markets or should they be keep away? Is there a third option if the two options fail to solve the current global financial crisis?
While the form of government might have little impact on the course of economic development and growth, state policies undoubtedly play a much greater role in shaping economic development in any country. The role of the state in the economy has been the subject of endless debate since the World War II.
The active role of the state in the economies of the newly independent countries was justified by the lack of basic active institutions, the absence of market dynamism and the much-needed infrastructure, not to mention the shortage in human and physical capitals.
A state can choose from the policy alternatives, the 'hands-off' approach and the 'interventionist' approach to stimulate economy.
The hands-off or laissez-faire approach is based on neoclassical 'wisdom', which assumes that the market can correct itself.
Neoclassical economic theory operates under the assumptions that perfect knowledge and perfect market equilibrium do exist. It advocates free market. But a prominent advocate of the invisible hands of the market and critic of the government's "stimulus" spending, Freidrich Hayek, contested 'The General Theory' of John Keynes and argued that governments should not be authorised to steer the market. He urged governments not to interfere with and limit the role of free market in the economy.
This line of thinking has been hugely undermined by the current financial crisis. There is common consensus that the crisis is a product of "the market system" itself rather than the outcome of external shocks such as "wars, revolutions, and, above all, political interference". The global financial crisis brought Keynes back to life.
Keynes's analysis of the Great Depression, redefined economics in the 1930s. The core of Keynesian Theory is that a government's intervention is needed to stabilise a national economy in both good and bad economic times, by running budget surpluses or budget deficits. He suggested that increased government spending during downturn could stimulate the economy by making more money available to flow.
The advocates of government intervention rejected the assumptions of neoclassical orthodoxy that market forces can correct market failures and argued that neither do 'we' live in a neoclassical world nor do 'we' possess perfect market knowledge. Developing countries, in particular, do not lack in market failures. However, the crucial question is: did Keynes really have a solution to the credit crisis? "No" believe economists, who think that Keynes' "Enhanced equilibrium theory is designed to keep the economy flying straight in normal conditions" while "credit crunches were alien to Keynes, and did not fit within his framework".
The argument that 'markets are efficient on their own' was also challenged, and the validity of the assumption that when states intervene they do so efficiently was also questioned and contested by the public choice theorists. Public choice theory raises the possibility of government failure and argues that governments can and often do fail; hence, this tends to deny the effectiveness of state intervention even when market inefficiencies are evident.
Rasem N. Kayed teaches at Massey University, New Zealand and M. Kabir Hassan teaches at University of New Orleans, USA
THE economic crisis, which grew in the US out of cheap credit, gradually engulfed the world. Low interest rates created demand for loans which the borrowers could not repay. Such rates in the United States made mortgages more affordable. The banks, driven by a sense of invulnerability and the desire to maximise their returns, adopted an easy approach to lending to make more money in fees and commissions. In such an environment, "loan volume gained greater priority over loan quality." 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 sharply plummeted. The problem was aggravated by the questionable tactics adopted by mortgage brokers who opted to sell to customers subprime loans. Intermediary players sought to pass the entire risk of default to the final purchasers to further complicate the situation.
Several factors contributed directly or indirectly to what became a global crisis triggered by the US subprime mortgage calamity and the subsequent collapse of the US financial institutions. Derivatives and excessive leveraging of US financial institutions drove global financial institutions into bankruptcies and brought others to the edge of collapse. Financial globalisation played a key role in enabling hasty transfer of systemic risk within and across national boundaries.
The financial crisis, driven by greed and speculation, tore down the world's financial system. An intense competition for higher returns encouraged excessive risk taking and lured banks to extend credit to unworthy borrowers who normally do not qualify for loans under prime lending criteria. 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 concluded and executed on papers, were sold and bought, though they had no economic value. Poor and inadequate regulation and lax lending standards made it easy for lenders to sign-off loans. Borrowers accessed loans beyond their capacity to repay.
Good and poor quality mortgages were packaged together and the mortgage-backed securities were sold to secondary investors in the intermediary market, generating massive earnings for the lending institutions and key staff and directors in the form of fees and bonuses. The extra cash allowed the banks to extend new loans to make more money. The model worked well so long the borrowers were repaying. But when the borrowers could no more repay, the system callapsed.
The financial crisis was caused by an impatience of lenders to sign-off loans on 'give-away terms' and their deliberate failure to ensure the creditworthiness of the borrowers, the failure of the regulators to regulate the market, and of the borrowers to take loans they cannot repay.
Not only Islamic financial scholars but also western economists consider the global financial crisis, a crisis of failed morality, caused by greed, exploitation and corruption. It is evident that originators of subprime loans deliberately failed to communicate potential risks involved in these transactions to the borrowers or investors.
What began as a limited subprime mortgage crisis in the US real estate market grew to be the world's biggest financial crisis since the 1930s. The impact of the crisis continues to be felt worldwide. Individuals have been directly or indirectly affected by the crisis as it hit almost every sector of the world's economy. World economies are yet to devise strategies on how to deal with the crisis.
The conventional financial institutions, by and large, were the first to feel the impact of the crisis they had initiated. The unparalleled events of 2008 created mass uncertainty, a sharp decline in global equity markets, the collapse of global financial institutions, the governments in industrialised countries came out with massive bail-out funds to revive their economies and commodity and oil prices sky rocketted and later slumped. The central banks cut lending rates to increase liquidity in vain effort to ward off recession.
The financial sector gloom forced Chief Executive Officers (CEOs) to resign as bankruptcy gripped world-class financial institutions like HSBC, Merrill, Citigroup, AIG and Lehman Brothers. The collapse of American, European and Asian security made even the wealthy overnight paupers.
Lehman Brothers Holdings (LEH) filed for bankruptcy in September 2008, when its assets were valued at $43 billion, making it one of the largest bankruptcies in the real estate history. An unprecedented $180 billion government bail-out for the American International Group (AIG) apparently proved not good enough to rescue the insurance giant. Oil prices reached levels beyond the imaginations of oil exporting as well as oil importing countries alike. Yet nobody could offer any explanation as to why oil prices rose and fell like this.
Economists, financial experts and politicians alike do not expect the crisis to end any time soon. They all warn that the hard times could prolong as the world's major economies continue to sink deep into recession
In this context, it is relevant to examine the immediate impact of the crisis on Islamic banking and the potential of Islamic banking to solve it. The direct impact of the crisis on the Islamic banking system was minimal due in part to the intrinsic principles followed by it.
Emmanuel Volland, analyst with the rating agency, Standard and Poor's, explains that "Islamic banks were not caught by toxic assets as Shariah law prohibits interest". Furthermore, the lack of structured products and the reluctance of Islamic banks to exploit sophisticated financial instruments enabled these banks to stay off the crises. Praising the cautious approach adopted by Islamic banking, Amr al-Faisal, a board member of Dar al-Mal al-Islami, commented, "We are more conservative and sober in our investments. What used to be considered a handicap is now "considered the height of wisdom". In fact, successful banks have always been "conservative lenders".
Although Islamic finance has not felt 'the full impact' of the global credit crisis, the immediate fallout from the crisis is evidenced by the fall in equity valuations and the plunge in the real estate market across the Gulf States with all that entails for the Islamic banking system. Lending under Islamic law is based on the concept of asset backing, where real estate is the preferred instrument to protect these investments. According to Standard and Poor's (S&P), the Islamic financial sector also has suffered a sharp decrease in the value of sukuk (Islamic financial certificate, similar to a bond in Western finance, complies with Shariah) issued in the year 2008 to the tune of $14.9 billion, down from $30.8 billion in 2007. Malaysia led in Islamic finance in 2009. Moreover, uncertainties in the global financial markets are, by and large, adversely impacting on the Islamic financial industry.
As to the long-term implications, Standard and Poor's believes that while the immediate future for Islamic financial institutions was uncertain, they have strong long-term prospects. The resilience of Islamic banking and its ability to navigate to safe shores depend largely on the competence of the human capital in charge of Islamic banking and its sincerity in reflecting and integrating the ethos of Islamic teachings into all aspects of the financial industry. The shortcomings of the Islamic financial system are most likely to prevent it from assuming a leading role in the international financial market. "The system is still in its infancy" and "not fully prepared at present time to play a significant role in ensuring the health and stability of the international financial system". Islamic banks need to diversify their funding sources beyond retail deposits and further develop and diversify new and existing products such as Islamic hedging, derivatives, liquidity and risk-management instruments. The Islamic financial system is on the right track and is expected to sustain steady growth and progressively establish itself as an influential and constructive key player in the international financial market.
According to a different reading, which the "immaturity of the Islamic financial industry has, in part, saved it from a subprime-like mess so far," "what will save it when the industry grows up?" they ask.
The west's search for 'the solution' to the crisis thus far proved to be 'mission impossible'. Should governments intervene in markets or should they be keep away? Is there a third option if the two options fail to solve the current global financial crisis?
While the form of government might have little impact on the course of economic development and growth, state policies undoubtedly play a much greater role in shaping economic development in any country. The role of the state in the economy has been the subject of endless debate since the World War II.
The active role of the state in the economies of the newly independent countries was justified by the lack of basic active institutions, the absence of market dynamism and the much-needed infrastructure, not to mention the shortage in human and physical capitals.
A state can choose from the policy alternatives, the 'hands-off' approach and the 'interventionist' approach to stimulate economy.
The hands-off or laissez-faire approach is based on neoclassical 'wisdom', which assumes that the market can correct itself.
Neoclassical economic theory operates under the assumptions that perfect knowledge and perfect market equilibrium do exist. It advocates free market. But a prominent advocate of the invisible hands of the market and critic of the government's "stimulus" spending, Freidrich Hayek, contested 'The General Theory' of John Keynes and argued that governments should not be authorised to steer the market. He urged governments not to interfere with and limit the role of free market in the economy.
This line of thinking has been hugely undermined by the current financial crisis. There is common consensus that the crisis is a product of "the market system" itself rather than the outcome of external shocks such as "wars, revolutions, and, above all, political interference". The global financial crisis brought Keynes back to life.
Keynes's analysis of the Great Depression, redefined economics in the 1930s. The core of Keynesian Theory is that a government's intervention is needed to stabilise a national economy in both good and bad economic times, by running budget surpluses or budget deficits. He suggested that increased government spending during downturn could stimulate the economy by making more money available to flow.
The advocates of government intervention rejected the assumptions of neoclassical orthodoxy that market forces can correct market failures and argued that neither do 'we' live in a neoclassical world nor do 'we' possess perfect market knowledge. Developing countries, in particular, do not lack in market failures. However, the crucial question is: did Keynes really have a solution to the credit crisis? "No" believe economists, who think that Keynes' "Enhanced equilibrium theory is designed to keep the economy flying straight in normal conditions" while "credit crunches were alien to Keynes, and did not fit within his framework".
The argument that 'markets are efficient on their own' was also challenged, and the validity of the assumption that when states intervene they do so efficiently was also questioned and contested by the public choice theorists. Public choice theory raises the possibility of government failure and argues that governments can and often do fail; hence, this tends to deny the effectiveness of state intervention even when market inefficiencies are evident.
Rasem N. Kayed teaches at Massey University, New Zealand and M. Kabir Hassan teaches at University of New Orleans, USA