Islamic Banking in Averting Financial Crisis - Essay Example

Islamic Banking and the Global Financial Crisis al Affiliation Introduction In this work, I will discuss the contributionof global banking policy in relation to the Islamic banking practices in an attempt to find out whether such practices can really be the savior of the economic crisis in the world today (Venardos, 2010). This discussion will view global banking policies as things that are not closely linked with cultural attitudes, but which have been allowed to roam free in search of growth and profit. In addition, the focus will incline more on the financial crisis worldwide and more so, on the financial markets and highlight some factors that have led to the crisis. Also, the focus will be on the Islamic economy to bring out how such factors will bring stability that the world is in need of (In Ahmed, In Asutay & In Wilson, 2014). The world could be in the midst of financial crisis which puts a lot pressure on the world’s economic recession. Islamic credit brought a lot of worries and confusion in that period of 2007 when economic depression was experienced making United States’ markets to rupture. An experience of the economic crisis is very threatening in that it brings into a stand still all the economic development due to increased prosperity and employment especially in the western economies and more so this leads into too much loss in the world economy (Kettell, 2011). Examining this topic will help in the understanding and appreciating of the roles of banking in diverse backgrounds (Kim & McKenzie, 2010). This can help borrow some knowledge in terms of rules and regulation that govern the banking activities in Arabic countries which can then be implemented in our banks. For example, Islamic banking holds fast on the principles of Sharia Law in which it is characterized by prevention of interest application on the loans given, and more so limiting excessive financial speculation (In Ahmed, In Asutay & In Wilson, 2014).The study of this topic gives me an understanding of international finance in that it gives the major causes of financial crisis, it impacts and also its effects (El, 2011). The financial crisis of 2007 had two major effects to the United States. First is that banks were unwilling to give or lend money which in turn increased the prices of borrowing. For example, the bonds that had been issued against different mortgages turned down $1.9 billion, in just a year, to $500 million in the year 2008 (Venardos, 2010). Second is that very many financial institutions became devastated, especially in the private finance initiative industry, single-line insurers that give security to bonds were forced to raise money for the private financial initiative projects (In Ahmed, In Asutay & In Wilson, 2014). On the other hand, the third world countries were also not left behind. This included the likes of Indonesia, Bangladesh, Malaysia, South America, Pakistan, Africa and more so the Middle East countries (Kim & McKenzie, 2010). All these countries had the same initiative of free markets which later led to capitalistic financial markets in which large amount of wealth were a major subject to theories without firm evidences on the economy’s state and projected revenue flows (Kettell, 2011). Just like the earlier crisis, much information has been developed on the possible reason for the current crisis (El, 2011). Economist have developed and brought into lime light the possible causes of such credit crises due to the lack of legislations, proper policies and transparency. It is worth noting that the current crisis holds similar characteristic to the previous crisis that took place from the period of great depression that occurred in the 1930. In both situations there are factors that are a major cause of this current food, oil, and credit crises (Venardos, 2010). These factors still revolve in the western countries and those countries that tend to imitate them. In addition, this credit crisis has also brought up weakness of the free market economy and capitalism; as the fight for the credit crisis and larger economic crisis goes on, the need for an alternative still continue to grow (Dridi & Hasan, 2010). Islamic economists still refer the major cause of global economic crisis as the interest rates (Riba) since the Western great depression crisis (In Ahmed, In Asutay & In Wilson, 2014). In this regard, they view this in terms of excessive monetary growths, huge budgetary disparities, scanty foreign aid, large balance of payments deficits, and deficient international cooperation as major causes of these problems of the economic crises (Abdul-Rahman, 2010). Welfare, equity and justice are the major guiding principles in the Islamic economic system. Islam based economists are in the process of coming up with an economic system which has a broad base in terms of the well-being with which employment is not a problem as all person are employed and that the economic growth is at its optimum position (Kim & McKenzie, 2010). In this regard, there will be egalitarian distribution of income and wealth and socio-economic justice. In addition, the economist will also ensure that a monetary value is stable in its function as a medium of exchange, genuine unit of account and store of value (Dridi & Hasan, 2010). Islamic banking system aims to be at equilibrium between tolerance, and misunderstanding or mistakes (Kettell, 2011). The supporters of the Islamic banking system look forward to seeing the economic or credit crisis not taking in the Islam-based financial institutions since the system operates in terms of partnership between the banks and the clients who tend to form some kind of obligation within finance and the Islamic banking (Venardos, 2010). Real Economy vs. Financial Economy Western countries, for about 30 years ago, have greatly moved their focus from the industry into services. The service sector currently accounts for about 80% of the total U.S. economy in which the financial sector represents the largest service (Venardos, 2010). There is more than just working the real world since people affiliated with the financial industry take a risk on what is likely to take place in the real world, having bets on how business is going to perform in terms of their profits. Financial sector survive in correspondence to the real economy and in return produces nothing real. Real economy is made up of land and property, housing, cars and goods, factories among other things. In economics, these are referred to as goods that are palpable and are used in trading, leases or even sold (Venardos, 2010). These can be termed as physical goods that are produced and or rather in which people are employed to produce them. However, financial economy is made up of financial statements with values that appreciate and depreciate depending on the values installed to them by the people (Davies & Green, 2010). Today, financial economy is far much valued than real economy (In Ahmed, In Asutay & In Wilson, 2014). For example, the world bond is approximated to be about $45 trillion, the world stock market to be $51 trillion and the derivative market is approximated to be about $480 trillion, which is more than 30 times the U.S. economy and 12 times that of the entire world. The fiscal markets have become so much separated from the real economy such that the financiers no longer search for dividends; instead, they look to acquire benefits of inflated price rises (Kim & McKenzie, 2010). This has led to a lot of speculations of enormous proportions that involves chances that the world economies might collapse. However, no solution has been given by the economists and politicians to curb such incidences up to this moment (In Ahmed, In Asutay & In Wilson, 2014). Debt Crisis and Sub-Prime Fantasy The credit crisis was felt after the banks realized that they had bought huge amounts of mortgages for Americans who never met their payments (El, 2011). In the opinion of the Institute of International Finance, the banks wrote down a total of $476 billion in which interns proved their assets to be worthless. There before, banks were only using the money loaded by the depositors to give loans to their clients since they were not suppose to get money from any other sources except from depositors (Dridi & Hasan, 2010). However, with changes in technology and different advancements, there are other sources from which the bank can access money other than only relying on the depositors’ money (Venardos, 2010). This involves the use of wholesale money markets in which a bank borrows money from the banks and sells it back to the borrowers at higher interest rates. Credit Default Swaps (CDSs) development made this possible. CDSs enabled the bank to be able to protect itself against the contingency that a client borrowing may end up owing enormous debts due to his/her default on payment. This brought a mirage that loans became less risky and thus such loans were able to be bought and sold as a result (Kim & McKenzie, 2010). This in return led to the development of collateralized debt obligation (CDOs) that banks bought as interest-bearing investments (In Ahmed, In Asutay & In Wilson, 2014).The sub-prime lender did not want to waste any sub-prime market possibility which forced them to come up with a much riskier method as they developed some complex products through sub-prime mortgage market sub-division (Abdul-Rahman, 2010). This process grew more complex as debt was now purchased by third party buyers who would then indulge in the loan repayment with some extra fee. In this regard, therefore, debt became similar to an asset as they were both tradable. The ability to insure debt provided means through which debt risk was shared giving way for the selling of more mortgages (In Ahmed, In Asutay & In Wilson, 2014).This practice of giving security to loans rose in 1994 from 32% to 77% of the aggregate sub-prime loans. This in turn resulted to the increment in the number of financial institutions in relation to the sub-prime mortgage market. Moreover, many institutions became the true holders of the Mortgage-Backed Securities (MBSs) that were formed by putting together different loans. This is whereby loans are put together by a bank and then the bank sells them as one product, collectively as debts (Venardos, 2010). It is imperative to note that after selling it at a fee, the now new holder receives regular repayments. This forms an asset or bond consisting of a set of mortgaged-based debts with which each has different extent of chances coming with it, and the owners of the MBS actually are not aware of where the payment is coming from. As per June 2008, the MBS market worth was about $6 trillion more than the treasury bond. It has been demonstrated very clearly by the financial crisis that the obvious modern financial markets’ strength was illusionary (Kettell, 2011). The good moments that were experienced disappeared instantly, the coming up of great losses was witnessed, accompanied by the dismissals of the senior officials, and followed by the real victims of the credit crunch getting punitive lending. In addition, inflation came in to worsen what was already there since the need for oil and food was high all over the world at this moment which in turn gave rise to increased prices hence the inflation. This has highly disturbed the entire political spectrum and the different economic schools on the possible cause of these crises. Policy makers and economists have suggested much more in terms of accountability and regulations, with a few giving details of how greed and speculations played a great role in the downfall (Davies & Green, 2010). Islamic Economics Islam does not support the capitalist or communist financial individuals. But in reality, both socialists and capitalists share some things with the Islamists (Kim & McKenzie, 2010). Elements that are common in both capitalist, socialist and Islam is the fact that they encourage people to work, and to yield some output and pocket more. Islam promotes empowerment of individuals by creating awareness subsequently in the minds and hearts of believers, and requires them not to be controlled by greed or attached to money excessively (In Ahmed, In Asutay & In Wilson, 2014). The Islamic financial and economic system is based on a set of ideals, values and morals such as co-operation, integrity, clear evidence, accountability, facilitation, honesty, complimentarily and solidarity (Kim & McKenzie, 2010). These principles and ideals are very important due to the fact that they ensure security, solidity and safety for all those associated with financial transactions. In addition, Sharia law forbids financial and economic transactions that are concerned with betting, interest, taking peoples’ money unfairly, cheating, greed, threat and doubt, domination, misuse, unfairness and dishonesty (In Ahmed, In Asutay & In Wilson, 2014). Financial Economics and Islamic Economics The philosophical guidance for the Islam is completely different on matters regarding economy which in turn give rise to a different society from that of capitalist one. Islamic economic system is very secure and satisfies the needs of individuals satisfactorily. In this regard, Islam views people as individuals rather than collectively as a society. This means that economic policies are meant to satisfy all people rather than just the market (Kettell, 2011). To achieve this, the distribution of wealth should be looked into and more so, the government should look into the economy and propagate it towards the direction of Islam (Abdul-Rahman, 2010). Both capitalists and the Islam system acknowledge money as a medium of exchange in an economic system with a foundation related to the financial market, and more so, that which permits money to be handled like any other product which can be exchanged for profit (Venardos, 2010). However, some Islamic scholars advocate that money should viewed as an asset backed and more so, consider it bad to allow money to be exchanged for money not only at par (In Ahmed, In Asutay & In Wilson, 2014). The Islamists view this in terms of allowing banks to lend out money at an interest allows the banks to get more money at an expense of the whole society, especially the poor, which results in an inevitable charge that economic system is always for the rich and against the poor (Davies & Green, 2010). Islamic Banking and Financial crisis The current financial crisis would not be witnessed if and only if the requirements of the Sharia laws were put in place in our economic policies and implemented to the letter (Kim & McKenzie, 2010). A good example is the case of sharing risk (In Ahmed, In Asutay & In Wilson, 2014). Imagine that commercial banks are required by the law to divide the losses and profits of their customers in such areas as business investment mortgages. This would create some sense of care in which deals go into financing them (El, 2011). This is so because their returns would be highly dependent on the projects’ performance. An Islamic sharia law governed banking system would completely do away with the interest and more so, the strained money creation through such processes of fractional reserves (Venardos, 2010). Fractional lending involves the practices carried out by banks in which more lending is made beyond what is actually in the bank’s deposits. Such acts of the bank places the economy in a very big problem since negligible equity can be used as surety to borrow enormous amounts of money thus creating financial problems (Dridi & Hasan, 2010). Islamic banks, operating under Islamic economy policies, accept money from its citizen and in return invest the deposits into the economy to generate profits, and later share that money amongst its depositors (Kettell, 2011). This puts Islamic banks as investment partners for the people who are in requirement of money to do business, thereby being co-owners of the business (Hayʼat Markaz Qaṭar lil-Māl, 2010). At the end, the bank should only sell the mortgages to get back it principal money. Islamic banks should not have opposition being in possession of real assets as they are true partners and therefore, should be prepared to split the significant risk. This scheme, although apparently insignificant, could make up a major relief to clients of the Islamic banks, since they would avoid fears of reclamation and debts troubles. Islamic banking just like other banks faces a lot challenges and more so the fact that it is still in its infant stage. The challenge worsens by the fact that it operates in an economy which is controlled and influenced by interest. The banking sector is always supported and controlled by the central bank in a financial economy (Venardos, 2010). The laws and regulation that are implemented by the central bank are regulated and put forward for all commercial banks, and serves as a leader at last resort. Despite the presence of such opportunities, many Islamic banks do not boast such benefits. Next challenge is that Islamic banks work in accordance with operational procedures that are conflicting with those of the conventional banks (In Ahmed, In Asutay & In Wilson, 2014). Due to these incompatibility issues, the Islamic banks are not controlled or even given support in case of liquidity gap (Davies & Green, 2010). Next problem is based on the fact that the bank is operating in the same system like other banking industries (Abdul-Rahman, 2010). In this regard, it could also face challenges being faced by other banks such as improper regulation; Islamic banks are rarely involved in sharing risks, which means clients in the bank who default suffer the same impact interest-based banks’ clients (Kim & McKenzie, 2010). If Islamic banks are involved in the creation of money, they will also suffer identical boom-bust cycle and inflation that is evident in Western economies. In terms of sharing risk, lending in conventional banks is secured by collaterals which separate bankers from the risks of their clients. This results in a heavy conflict of interest (Kettell, 2011). Conventional banks also distort those who are already rich from being provided with funds. People who are destitute and have reasonable ideas but no securities to offer often fail to get finance under this system, leading to large gaps in the variations of wealth which increases from generation to generation. Risk-sharing finance of the Islamic banks should deal with such disputes and bring superior steadiness to the economic activities. If the value of the liabilities of an Islamic bank is determined by the presentation of its property, the sub-prime crisis would not be prevalent (Hayʼat Markaz Qaṭar lil-Māl, 2010). Regrettably, the techniques of risk-sharing do not prevail in the world of modern finance. Actually, the intention is frequently the contrary. Conventional bankers and entrepreneurs have a liking of increasing the excessive risk, and then preventing themselves from it so as to increase their capital returns (In Ahmed, In Asutay & In Wilson, 2014). In this way, there is the possibility of an entrepreneur to borrow cash from a bank at a fixed interest and then invest in a profit generating company. Out of this borrowed money, the entrepreneur is capable of keeping his profit. Entrepreneurs are thereby motivated by such incentives and they borrow heavily and grow their business operations more efficiently (Kettell, 2011). One setback of this style is that a few successful business enterprises have come to control the business fraternity. The substantial gratitude of this kind of corporations implies that a reasonable rise in interest rates united with a reasonable fall in revenues can dramatically corrode the total realized margin of profits. This is one of the main causes of the significant change in share prices over relatively short periods (Kim & McKenzie, 2010). Moreover, the bank’s finance interest charges are a cost item in the construction process and thus serve to raise the prices of services and goods. The society itself develops the interest expenditure which they obtain from the conventional banking system. In terms of money creation, the most powerful undermining factor of all in contemporary markets is the money creation activity carried out by the conventional banking system (Venardos, 2010). By putting money that is created out of nothing into circulation, commercial banks and also central banks have together caused a succession of unavoidable problems that can be tracked back in the Western world to up to 300 years ago. When newly produced money is spent on assets such as shares and property, there is tendency of their prices to naturally increase (In Ahmed, In Asutay & In Wilson, 2014). On the other hand, when banks decrease the rate of money formation, prices begin to fall since the buyers move on or disappear. The means of being able to generate money is thus a hugely powerful economic and political tool, and one that is almost always abused at long last. It is imperative to note that two Islamic regulations in particular work to prevent the creation of money by the banking system (Kettell, 2011). These are the policies of prohibition of interest (Riba) and trust. In order to earn profit, modern banks have dismissed issuing promises of repayment in excess of their cash treasury and also lending these promises at an interest (Abdul-Rahman, 2010). Finally, the efficiency of Islamic financial institutions and the governments will play a critical role in eliminating this problem of economic crisis (Venardos, 2010). Governments can increase efforts to eradicate growth barriers and create a reliable business setting by strengthening and respecting property rights, increasing accountability, installing a well-functioning judiciary, and reducing violence and crime. This is critical since the private sector is the engine of productivity and innovation, and the main source of job creation and also revenues (Kettell, 2011). In conclusion it is evident the financial crisis has demonstrated very clearly that the obvious advantage of the modern financial markets was a mirage (Kim & McKenzie, 2010). The good moments that were experienced disappeared instantly, coming up of great losses was witnessed, accompanied by the dismissals of senior officials accompanied by more severe lending for the true victims of the credit crisis (Kettell, 2011). In addition, inflation came in to worsen what was already there since the need for oil and food was high all over the world at this moment which in turn gave rise to increased prices hence the inflation. This has highly disturbed the different economic schools and the entire political entities on the possible cause of these crises (Kim & McKenzie, 2010). Policy makers and economists have suggested much more in terms of policies and accountability with only few giving details of how greed and speculations played a great role in the downfall (Hayʼat Markaz Qaṭar lil-Māl, 2010). It is the best time for development of Islamic values globally to the economists, players in the market, commentators and the populous in general. They should be made to understand that Islam is greater than the exclusion of alms (zakah) and interest (riba), but it is a complete system used to provide the society’s basic requirements such food, clothing and shelter (Kettell, 2011). Islam promotes people and their needs, instead of assembling, the principal question. All the Sharia rules supplement each other in the presentation of the Islamic economic policy (Kim & McKenzie, 2010). This means Islam is more able of being put into practice and evidently, has a flourishing history of sorting out economic problems (Venardos, 2010). References Abdul-Rahman, Y. (2010).The Art of Islamic Banking and Finance: Tools and Techniques for Community-Based Banking. Hoboken, N.J: Wiley. Dridi, J., & Hasan, M. (2010). The Effects of the Global Crisis on Islamic and Conventional Banks. Washington: International Monetary Fund. Davies, H., & Green, D. (2010). Banking on the future: The fall and rise of central banking. Princeton, N.J: Princeton University Press. El, T. A. M. (2011). Islamic banking: How to manage risk and improve profitability. Hoboken, N.J: Wiley. Hayʼat Markaz Qaṭar lil-Māl. (2010). Islamic finance: Instruments and markets. London: Bloomsbury Information Ltd. In Ahmed, H., In Asutay, M., & In Wilson, R. (2014). Islamic banking and financial crisis: Reputation, stability and risks. Kettell, B. (2011).The Islamic Banking and Finance Workbook: Step-by-Step Exercises to Help you Master the Fundamentals of Islamic Banking and Finance. Chichester, U.K: Wiley. Kim, S.-J., & McKenzie, M. D. (2010). International Banking in the New Era: Post-Crisis Challenges and Opportunities. Bingley, U.K: Emerald. Venardos, A. M. (2010). Current issues in Islamic banking and finance: Resilience and Stability in the Present System. Singapore: World Scientific. Read More