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21/10/2008
THE GLOBAL FINANCIAL CRISIS AND THE ISLAMIC FINANCIAL SYSTEM
by
M. Umer Chapra*
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The author is Research Adviser at the Islamic Research and Training Institute (IRTI) of the Islamic Development Bank (IDB). This paper is a revised and updated version of the keynote Forum lecture delivered by him at the inaugural session of the Eighth Harvard University Forum on Islamic Finance held on 19-20 April 2008 in the Harvard Law School. The views expressed in this paper are his own and do not necessarily reflect those of IRTI or IDB. He is grateful to Shaikh Muhammad Rashid for the excellent secretarial assistance he has provided.
INTRODUCTION
The whole world is now in the grip of a financial crisis which is far more serious than any experienced over the last four decades. In spite of billions of dollars of bailout and liquidity injections by a number of industrial countries the crisis is showing no signs of abating. There is, hence, a call for a new architecture that would help minimize the frequency and severity of such crises in the future.
PRIMARY CAUSE OF THE CRISES
It is not possible to design a new architecture without first determining the primary cause of the crises. The generally recognized most important cause is excessive and imprudent lending by banks. This raises the question of what makes it possible for banks to resort to such an unhealthy practice. There are three factors that make this possible. One of these is the inadequate market discipline in the financial system resulting from the absence of profit and loss sharing (PLS). The second is the mind-boggling expansion in the size of derivatives, particularly credit default swaps ((CDSs), which are claimed to provide protection to lenders against default. The third 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 excessive leverage, and to an unsustainable rise in asset prices, living beyond means, and speculative investment. Unwinding later on gives rise to a steep decline in asset prices, and to financial frangibility and debt crisis, particularly if there is overindulgence in short sales. Jean Claude Trichet, President of the European Central Bank, has rightly pointed out that "a bubble is more likely to develop when investors can leverage their positions by investing borrowed funds".
The Subprime Mortgage Crisis
The subprime mortgage crisis in the grip of which the US finds itself at present, is also the result of excessive and imprudent lending. Securitization or the "originate-to-distribute" model of financing has played a crucial role in this. Mortgage originators collateralized the debt by mixing prime and subprime 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 subprime borrowers and speculators increased steeply. According to Mr. Bernanke, Chairman of the Board of Governors of the Federal Reserve System, "far too much of the lending in recent years was neither responsible nor prudent. ... In addition, abusive, unfair, or deceptive lending practices led some borrowers into mortgages that they would not have chosen knowingly". The check that market discipline could have exercised on the serving of self-interest did not, thus, come into play.
The result is that a number of banks have either failed or have had to be bailed out or nationalized by the governments in the US , the UK , Europe and a number of other countries. This has created uncertainty in the market and led to a credit crunch, which has made at hard for even healthy banks to find financing. There is a lurking fear that this might be only the tip of the iceberg. A lot more may come if the crisis spreads further and leads to a failure of credit card institutions, corporations, and derivatives dealers.
When there is excessive and imprudent lending and lenders are not confident of repayment, there is an 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 hedge 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. What happened, however, was that 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 a genuine insurance contract only the one actually insured claims compensation, in the case of CDSs several swap holders will claim compensation. This accentuates the risk and makes it difficult for the hedge funds and banks to honour their commitments. The notional amount of all outstanding derivatives (including CDSs of $54.6 trillion) is currently estimated by the Bank for International Settlements (BIS) to be $600 trillion, more than 10 times the size of the world economy. No wonder George Soros described derivatives as "hydrogen bombs", and Warren Buffett called them "financial weapons of mass destruction".
THE ISLAMIC FINANCIAL SYSTEM
One of the most important objectives of Islam is to realize greater justice in human society. According to the Qur'an a society where there is no justice will ultimately head towards decline and destruction (Al-Qur'an, 57:25). 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, in addition to being strong and stable, 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 mobilized 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 first 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 risks more carefully and to effectively monitor the use of funds by the borrowers. The double assessment of risks by both the financier and the entrepreneur should help inject greater discipline 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 businesses. Greater reliance on equity financing has supporters even in mainstream economics. Prof. Rogoff of Harvard University states that in an ideal world equity lending and direct investment would play a much bigger role.
Greater reliance on equity does not necessarily mean that debt financing is ruled out. 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 (murabahah, 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. It has, however, laid down a number of conditions, some of which are:
1. The asset which is being sold or leased must be real, and not imaginary or notional;
2. The seller must own and possess the goods being sold or leased;
3. The transaction must be a genuine trade transaction with full intention of giving and taking delivery; and
4. The debt cannot be sold and thus the risk associated with it cannot be transferred to someone else. It must be borne by the creditor himself.
The first condition will help eliminate most of speculative transactions which involve gharar (excessive uncertainty) and qimar (gambling). The second condition will help ensure that the seller (or lessor) also shares a part of the risk to be able to get a share in the return. Once the seller (financier) acquires ownership and possession of the goods for sale or lease, he/she bears the risk. The Shari'ah has made an exception to this rule in the case of salam and istisna where the goods are not already available in the market and need to be produced before delivery. Financing extended through the Islamic modes can thus expand only in step with the rise of the real economy and thereby help curb excessive credit expansion.
The third and fourth conditions, that the transaction must be a genuine trade transaction and that the creditor cannot transfer the risk to someone else by selling the debt, will also help eliminate a great deal of speculative and derivative transactions where there is no intention of giving or taking delivery. It will also help prevent an unnecessary explosion in the volume and value of transactions and the debt from rising far above the size of the real economy. It will also release a greater volume of financial resources for the real rector and, thereby, help expand employment and self-employment opportunities and the production of need-fulfilling goods and services. The discipline that Islam wishes to introduce in the financial system may not materialize unless the governments reduce their borrowing from the central bank to a level that is in harmony with the goal of price and financial stability.
In keeping with the Islamic goal of promoting justice it is also necessary to introduce some suitable innovation in the financial system to ensure that even small borrowers, who are generally assumed to be subprime, are also able to get adequate credit to enable them to realize their dream of owning their own homes and establishing their own microenterprises.
There is no doubt that a number of countries have, established special institutions to grant credit to the poor and lower middle class entrepreneurs. Even though these have been extremely useful, there are two major problems that need to be resolved. One of these is the high cost of finance ranging from 30 to 70 percent in the interest-oriented microfinance system. This causes serious hardship to the borrowers in servicing their debt. No wonder, the Minister of Finance for Bangladesh described microcredit interest rates in that country as extortionate in an address he delivered at a microcredit summit in Dhaka in 2004. It is, therefore, important that, microcredit is provided to the very poor on a humane interest-free basis (qard hasan). This may be possible if the microfinance system is integrated with zakah and awaqf institutions. For those who can afford to bear the cost of microfinance, it would be better to popularize the Islamic modes of profit-and-loss sharing and sales- and lease-based modes of finance not only to avoid interest but also to prevent the misuse of credit for personal consumption.
Another problem faced by microfinance is that the resources at the disposal of microfinance institutions are inadequate. This problem may be difficult to solve unless the microfinance sector is scaled up by integrating it with the commercial banks. Commercial banks do not generally lend to small borrowers because of the higher risk and expense involved in such financing. It is, therefore, important to reduce their risk and expense. This may be done partly by a subsidy from zakah and awqaf funds for those borrowers who are eligible for zakah..
Thus we can see that the Islamic financial system is capable of minimizing the severity and frequency of financial crises by getting rid of the major weaknesses 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 growth of the real economy and minimizes gharar and qimar by allowing credit primarily for the purchase of real goods and services which the seller owns and possesses and the buyer wishes to take delivery. 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 that are spent after the crisis to bail out the rich bankers. 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, of course, 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.
----- Original Message -----From: MChapra@isdb.orgSent: Tuesday, October 21, 2008 4:56 AMSubject: Re: Fw: New book of Shah Abdul Hannan published in the Internet
I am attaching the brief version of a paper I have prepared for a Forum scheduled to be hda in the IDB on Saturday. If you find it worthwhile, you may send it to some widely circulated newspaper for publication.
M. Umer Chapra
Islamic Development Bank Group e-mail Disclaimer:
(http://www.isdb.org/irj/go/km/docs/documents/email_disclaimer.html )
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