The Principles of Islamic Finance: the Primary Source of Global Finance - Research Paper Example

Abstract This paper seeks to analyse the elements of the international financial crisis which has engulfed the world over the past 3 years and ask whether the core principles of Islamic finance have sheltered the Islamic finance industry from the worst of this crisis. Examining the core causes of the crisis, how it developed and the key players such as ratings agencies and subprime lenders, the paper suggests that elements of Islamic finance have prevented many of the negative repercussions that have swept through the Western financial industry. From the prohibition of interest to forbidding uncertainty in investments, the core characteristics of Islamic finance are examined in term, demonstrating that the virtuous circle of risk creation that existed in the Western financial system was never supported by their Islamic counterparts. The fact that collateralised debt obligations are outlawed and risk is always shared by the lender and debtor add to a system which this paper argues promotes greater stability. It is suggested that the ongoing growth of the Islamic industry has been protected and that if Islamic finance maintains its focus on its core principles its future will be secure as it attracts conservative investors. Introduction From February 2007 a number of events started to unfold which would represent the beginning of possibly the most acute financial crisis of a generation. With its foundations in a financial system singularly motivated by the continual search for large profits and built on Western practices that embraced complex financial products and excessive levels of debt, the credit crisis that ensued would expose some of the dangerous weaknesses in the system. These weaknesses threatened not only the financial architecture but also, as some argued in the darker days of 07/08, the very functioning of society. Roubini in September 2008 ‘This will turn out to be the worst financial crisis since the Great Depression and the worst US recession in decades.’1 As we now know, since 2008 governments around the world have had to go to unprecedented lengths to keep the financial system running by reducing interest rates to historic lows for extended periods and injecting vast amounts of resources into national economies. These early reactions to the crisis and its repercussions on society have led to a second stage of austerity measures as governments seek to reduce spending in order to deal with the debts that they have accumulated through supporting the financial system and, in the case of the UK, to all intents and purposes nationalising a number of banks. On the back of these events it is clearly not an exaggeration to suggest that the there are significant question marks surrounding the status quo in the international financial architecture and what can be done to reduce the risk of another such crisis in the future. It is in this context that the merits of Islamic finance have come under scrutiny as it would appear that while Western systems have fared so badly during this crisis and have actually been at the heart of the problems, the world of Islamic finance appears to have been well insulated from much of the negative repercussions. Islamic finance is founded on religious principles and in the context of this paper it is important to examine these in turn in order to determine whether it is the principles themselves which have been the most important aspect in protecting the Islamic finance industry. While these principles will have a significant bearing on the functioning of the Islamic finance industry it has to be asked whether other factors such as being geographically removed from the crisis, having other regulatory systems that prevented the overspill of the crisis or simply an internal aversion towards Western products in the Islamic world had as much of an influence on the outcome of the crisis in the Islamic financial system. However in order to progress in answering the question at had this paper first needs to understand the factors that created and led to the deepening of the crisis as it is only with an appreciation for this that one can judge the influence of the Islamic finance principles on protecting the system they lie at the heart of. Background to the Crisis Cecchetti suggests that the financial crisis began ‘when several large subprime mortgage lenders started to report losses’2 in the February of 2007. This then had repercussions in the credit market where the difference in interest rates between high risk and low risk assets started to widen. However it was not until the August of that year that the bigger shock waves started to spread through the financial system as BNP Paribas halted redemptions on some of its funds due to its inability to accurately value them. These funds were funds related to subprime mortgage debt, that debt which had been accumulated by US borrowers who had to pay higher rates of interest on their borrowing due to their lower credit ratings. Once BNP Paribas had indicated that there were real concerns about the value of assets that it was holding in its funds, other companies started to question their own balance sheets and rather than continuing to offer cash on the interbank market, hold on to it due to fears of an oncoming asset value crash. Due to the fact that the large institutions stopped lending, the short term interest rate rocketed upwards simply on the back of the demand and supply equation. As the supply of money dried up, its cost increased. Cecchetti goes into detail on the chronology of events but for the purposes of this paper the following extract is particularly important. ‘There are two possible explanations for the unwillingness to lend. One is that lenders perceived a substantial increase in credit risk—that is, an increased risk that more borrowers will default. The alternative is that banks that normally would have been willing to lend faced a combination of uncertainties and constraints related to the size of their own balance sheets. This concern could have arisen from fears about both involuntary lending that banks might be forced to make because of prior commitments on credit lines, and fears of the declines in the value of assets that the banks were holding.’3 As we now know these fears about the quality of balance sheets was well founded with firms like Lehman Brothers suffering the ultimate consequence of bad loans and now failing to exist. Therefore, when looking at the question at hand one must ask to what extent might the Islamic approach to finance have mitigated the concerns of the banks or even have prevented banks getting into such a predicament in the first place. Are there elements of Islamic financing that prevent lenders forwarding credit to those who are likely to default and do banks within the Islamic financing system have a tighter control over the content of their balance sheet. In the context of what Cecchetti states here, if the system of Islamic finance places more scrutiny on the assets that they lend on, then this in itself must be a mechanism that would have insulated the system from the detrimental effects of this credit crisis. So while it was this sequence of events that led to the tightening of credit and the problems that would follow in the international financial architecture, it is also worth looking at the nature of some of the products that had developed by this time that were at the heart of the problems seen in the financial system. As has been mentioned, it was the subprime mortgage market that was at the heart of the financial crisis, however it must be understood that this was not simply a situation of lender and borrower. The use of derivative products in the Western financial system is one thing that magnified the conditions for the crisis and by their very complex nature caused much of the uncertainty in the system which meant Western banks walked blindly into the crisis. Derivative products are essentially financial products based on an underlying assets which is not owned by the holder of the derivative. In the case of the financial crisis it was securities based on subprime mortgage debt which had been created and sold for years among institutional and private investors which put in place a virtuous circle of risk creation. As Crotty notes, ‘Banks and mortgage brokers pushed mortgage sales because they earned fees in proportion to the volume of mortgages they wrote. Banks earned large fees securitizing mortgages, selling them to capital markets in the form of mortgage backed securities (MBSs) and collateralized debt obligations (CDOs), and servicing them after they were sold.’ 4 The system therefore faced a situation whereby the profit incentive meant that both key players in the system were highly motivated to keep selling mortgages and creating derivative products. Obviously as time goes on, the marginal mortgage applicant will represent a more risky proposition but to keep the revenue stream going and satisfy the demands of banks who will happily package up these loans into derivatives for sale, there is little disincentive to really scrutinise the quality of the income stream that is created. Not only that but due to the fact that it was banks putting these products together, investors had faith in the quality of the assets. What cannot be ignored either is that this ‘quality’ was in many cases underlined by the international ratings agencies that gave these derivative products very high or in some cases triple A ratings. Therefore when outside investors looked at these assets in the context of the overall investment spectrum they saw high quality, high returning assets, which for an investor are extremely attractive, providing a low risk high reward profile. Hellwig suggests that this was due to a combination of flawed risk models as well as due to conflicts of interest where the rating agencies also had branches that advised on how best to package up mortgage backed products. It must also be considered that the complexity of derivative products would have been a major hurdle for both investors and ratings agencies alike and created the opaque system whereby transparency was lacking and therefore risk was hidden Islamic Finance Principles in the Context of the Financial Crisis The aspects discussed above are the core elements that led to the credit crisis therefore to determine the extent to which Islamic finance was protected from the crisis it has to be asked how the principles of Islamic finance mitigated such a situation from arising internally and how, once the crisis ensued, the overspill was limited. Before entering into this discussion it is worth giving some historical context to the Islamic finance industry. Today’s modern Islamic financial services industry is entering its fourth decade of actual practice. It has evolved to contain under its umbrella an array of financial services that deal with both banking and non-banking financial services, the insurance markets and the capital markets. Although assessments of the exact size the market differ, the number of total assets that Salah mentioned that Islamic financial institutions hold is estimated to be 230 billion dollars with Islamic financial institutions scattered over 75 countries with an expected industry growth of 15% within the coming 5 years.5 The Islamic financial market is not one that is insignificant in size therefore it cannot be argued that simply because it is peripheral to the greater Western financial sector, this insulated it from the credit crisis. It is one of the fastest growing financial sectors with principles based on religious foundations and teachings of the Koran. As Atzori explains, ‘Islamic finance is based on shari’a (Islamic Law). According to Islamic tenants, interest (riba) and contractual uncertainty (gharar) are forbidden. In an Islamic framework, financial transactions must be based on tangible assets. Moreover investments in sectors considered haram (unlawful) by sharia, such as pornography, gambling and pork-related commodities are forbidden.6 Even on initial inspection of this description of Islamic finance it is possible to begin identifying why Islamic finance may have been so well insulated from the financial crisis. Given that interest is forbidden, the very products (mortgages) that were at the heart of the crisis could not exist in Islamic finance in the way they do in the West. Also if contractual uncertainty is forbidden then surely the likelihood of complex derivative style products being widespread is unlikely. This overview of Islamic finance is useful as from here this paper will examine a number of the core principles of Islamic finance in greater depth in order to address whether it is these that have been the source of insulation from the financial crisis. The ban on interest is at the heart of Islamic finance and therefore in the context of the credit crisis many elements that were at the root of the problems simply did not exist in the Islamic finance system. The interest that was being charged on subprime loans at a rate which reflected the higher risk of those loan takers was the very asset that was then sold on in the mortgage backed security products. These interest income streams which represented the profits investors would make by holding these derivative products would be forbidden in Islamic finance and therefore a whole financial sector that created a virtual circle of debt and risk accumulation is absent from the Islamic financial environment. While the absence of these products necessarily means that the same sort of crisis could not emerge in the Islamic financial centres, it also has to be highlighted why, once the crisis initiated in the West, Islamic finance was insulated from it. As was discussed above, the global relationship of interest rates is highly interconnected, therefore when the crisis occurred lending rates between different monetary areas quickly rocketed as credit dried up around the world. It would be naive to suggest that Islamic banks were not affected in some ways by this credit tightening, however simply because of the fact that a vast majority of their assets are outside of this interest rate influenced world, they would have been largely insulated from the worst of the problems. As Salah notes in regard to Islamic institutions, ‘They initially escaped some of the effects of the downturn because they were not loaded up with sub-prime debt and other toxic assets.’7 He does however go on to illuminate the negative repercussions upon Islamic institutions due to the down turn in the housing market and falling asset values. Despite this it is clear that simply because of the principle of riba being outlawed, Islamic finance was protected from much of the initial shockwaves. Given that Islamic finance does not offer mortgages with interest attached it must be asked what the alternative approach is and to what extent this might add to the stability of an Islamic bank. What is known as a Murabaha contract is the most common way of structuring the purchase of property through an Islamic bank. In this arrangement the individual looking to purchase the property is essentially entering into a partnership with the bank which culminates in a profit sharing arrangement. As Gait and Worthington point out ‘Mudarabah is a contract between two parties: an investor (individual or bank) who provides a second party, the entrepreneur, with financial resources to finance a particular enterprise. Profits are then shared between the two parties(rabb-al-mal and mudarib) according to some pre-agreed ratio.’8 Therefore, in the context of Islamic finance the relationship between the lender and the borrower is quite different to that found in normal Western financing practices and it could be argued prevents the Islamic finance houses exposing themselves to high levels of risk. The credit crisis has at its roots the extension of vast quantities of loans to those would ultimately could not afford to pay them. The incentive for firms was to get borrowers on to their books as it was this action which provided them with a fee for setting up the mortgages in the knowledge that once that had been achieved they would be able to sell on the mortgages to larger institutions. These institutions were also happy to take on these mortgages as they could very quickly sell them on to investors who were attracted by the higher returns at ‘low’ risk. In each of these transactions the reward was a short term one with no incentive to check the long term competency of the investor or the quality of the assets that were created and sold on. This short termism, motivated by the profit incentive was a major flaw in the system and one, it could be argued, is far less likely to occur if a mudarabah contract is in place. Importantly in this situation it is the fact that the relationship is one of a partnership that is the key. Given that the banks have a vested interest in the long term viability of any individual they enter into a contract with, the likelihood of accumulating vast amounts of bad debts is greatly reduced. This in itself indicates the potential benefits of using loan systems more akin to those adopted by Islamic finance but also this would have been a factor that protected the system once the recent crisis began. This can be suggested as ultimately the quality of assets on the books of Islamic institutions could be assumed to be of better quality and therefore the problems experienced in the West of unclear balance sheet valuations and asset value collapses would not have been as significant, if a problem at all. One of the other core principles of Islamic finance is the prohibition of gharar. Gharar which has its Arabic root in a word meaning deception is applied in the context of Islamic finance to ‘prohibit enforcing unfair contracts that involve risk and speculation (gharar).’9 This principle has specific repercussions on the type of instruments that Islamic banking can incorporate into its overall offering as El-Gamal notes, ‘The prohibition of gharar was also invoked to forbid derivative securities, but forwards and options were easily synthesized from the ancient contracts of salam (prepaid forward sale) and `urbun (downpayment call option), respectively.’10 In this context this principle of Islamic finance prevented the creation of anything akin to the credit default swaps and structured products, known as derivatives, which went a long way to incentivising the accumulation of more and more unstable debt in the global system. This prohibition of derivatives clearly could not prevent the Islamic finance sector suffering as global asset prices and confidence dropped however it did not put Islamic banks and investors in the position of uncertainty which Ceccheti describes above whereby there was little clarity about overall asset values. Derivatives have clearly been identified by the Islamic finance world as a product that is inherently uncertain and with hindsight a more applicable label could not have been applied to them. It was their complexity which, it can be argued, was one of the primary causes of the credit crisis due to the fact that as soon as banks came under pressure and needed to value their balance sheets it was this element of their assets which they had very little chance of accurately valuing. It was this that led directly to the credit tightening as banks did whatever they could to safe guard their assets by holding on to their cash. Therefore despite the fact that the global crisis would go on to affect banks and economies around the world, it is fair to suggest that during the emergence of the crisis, those elements of uncertainty as regards balance sheets were not experienced by the Islamic institutions to anything like the extent in the West. This is not to argue that Islamic banks would not have had exposure to property or assets that might have been falling in value but rather the assets that they did have were not represented by pieces of paper that had been created possibly second or third hand down the line from the bundling up of mortgage payments in a country or region they didn’t even know. By contrast the proximity of the banks to their assets would have been much closer and therefore their ability to value them and continue functioning with confidence, greatly reinforced. As Warren Buffet stated derivatives ‘are time bombs and "financial weapons of mass destruction" that could harm not only their buyers and sellers, but the whole economic system’11 With hindsight his insight into these products could not have been more accurate and interestingly his choice of analogy that uses terminolgy most commonly associated with the Middle East, in this case turns the tables on the Western world. Clearly the credit crisis derived in large part from the creation of derivatives that, due to the uncertainties attached, were outlawed in the Middle East. This undoubtedly has protected the Islamic finance industry from the ongoing financial turmoil. Ilias12 highlights that a third core principle of Islamic finance is that investors and institutions should share risk and profit. In the context of the derivative products discussed it is clear to see that a situation ensued whereby loans were being given and then the income streams sold on in a manner which shifted risk to buyers of the products and simply provided the incentive for banks to create more of these products to sell in the market. It would seem to be a fundamental element in any financial system that those extending credit should carry a portion of the risk of the transaction otherwise there are no internal controls to prevent the proliferation of bad loans. In the context of the credit crisis it would seem that this was largely bypassed through the use of derivatives. Obviously, in the end the attraction of creating such derivative products led to a proliferation which unbalanced the whole system regardless of who was formally bearing the ‘risk’ of the original mortgages. Crotty discusses this situation, highlighting that, ‘Securitization shifts loans from bank balance sheets to capital markets, where they are priced correctly and distributed optimally. This not only lowers banks’ risk, it frees up bank capital to create more loans.’13 One can see therefore that this interplay of derivative products and risk exposure played a large part in the proliferation of those financial weapons of mass destruction that would ultimately bring the whole system crashing down. The principle of risk and profit sharing therefore represents a direct antidote to the creation of such a situation as it would be inconceivable to expose an institution or individual to a certain level of risk that was then passed on to a third party. In essence Islamic finance is founded on the concept of partnership whereby credit providers and borrowers form an ongoing relationship becoming stake holders in projects that they will see through until culmination, whether that be good or bad. As Gamal highlights this is possibly the most important element of Islamic Banking. ‘An “Islamic bank” was envisioned as a two-tier silent partnership. Thus, deposits seeking a return (as opposed to fiduciary deposits, for which 100% reserves are required) would not be guaranteed loans to the bank, but rather silent-partnership investments in the bank’s portfolio. In turn, the bank’s investments of those funds would not consist of loans and acquisition of debt instruments, but rather profit-and-loss sharing investments in other silent partnerships. Thus, the Islamic bank would serve its financial intermediation function (pooling of return-seeking savings and diversification of investments) through profit-and-loss sharing. This idea continues to serve as the cornerstone of Islamic banking today’14 In the context of the financial crisis this approach to running a bank not only prevented the accumulation of high levels of risk but also meant that Islamic institutions would have had a very intimate understanding of the state of their overall balance sheets. In this partnership arrangement it is also clear that any loans being made would have been done with far more caution as profits of the bank would have been related directly to the success or failure of the individual projects for which capital was required. By contrast in the Western financial system it got to the point that the primary driver of profit for financial institutions was simply the volume of loans that could be extended such that more derivatives could be sold on to third parties. Clearly in this situation there is going to be a very limited incentive to scrutinise the quality of the loans being made. Building on this is the fourth principle of Islamic finance which Illias highlights as ‘Asset-backing’ whereby ‘each financial transaction must be tied to a “tangible, identifiable underlying asset”.’15 This principle comes back to a number of the key elements which magnified the outcome of the financial crisis and further demonstrates the internal elements of the Islamic financial system that has protected it from the credit crisis. Having tangible assets will clearly improve the transparency of the balance sheet, prevent the creation or acquisition of derivative products and lead to greater scrutinization of those assets which are acquired by the institution. This principle reinforces the essence of much of the other principles discussed and demonstrates that there are many elements that have protected Islamic finance industry from the credit crisis. This is summarised well by Agha, ‘Hardly any institution or investor has been immune to the turmoil, but in the last year many Islamic investments and institutions have weathered the storm in better shape than those of conventional banking markets. Islamic investments are asset-based because of prohibitions against interest-bearing loans and bifurcation of debt from assets, and have therefore remained relatively sheltered from the worst shocks of the financial markets.’16 The final principle of Islamic finance to mention is that which underlines the need for ethical investments that enhance society and avoid industries such as alcohol, pornography, gambling and pork based products. This principle would certainly have reduced the exposure of Islamic banks to Western institutions / funds that invest in these areas and therefore possibly offered even further insulation against the general downturn but aside from that it might be the tangible protection offered by this principle was limited. However on a philosophical level it certainly can be suggested that if Islamic investments are designed to enhance society then would Islamic banks have been so eager to offer loans to individuals who arguably were never really able to afford them. Potentially, given that the industry of Islamic finance is about helping the community it is involved with, the conditions that created such a situation would never have occurred if banks had had a more ethical stance towards investments. The principles of Islamic finance have clearly protected the industry from the credit crisis both in the sense of mitigating the exposure to the toxic products and also in relation to protecting its future. The credit crisis has threatened the future of the Western financial system with moves underway to change regulation and a number of institutions disappearing all together. By contrast it could be argued that the Islamic finance industry has had its future bolstered as people now see it as a conservative approach to finance which avoids the dangerous products and practices of the Western world that people are no longer so keen to be exposed to. However before concluding that the principles of Islamic finance have left it as a sector untouched by the credit crisis this analysis must be tempered. The credit crisis has clearly had global repercussions and the Islamic world has not been immune to these. As asset values have fallen, centres of the Islamic finance industry have come under pressure with Dubai being the most notable among these. In this case though it was not so much the internal elements of the Islamic financing that were at fault but a combination of a global down turn and an economy largely based on the construction and sale of properties. Specific areas of Islamic finance have come under pressure though as Salah notes, ‘So when we look at the drop off in Sukuk issuances in 2008 from 2007 levels, there are two factors in play: the credit market crunch clearly had an impact, but there was also a decline attributable to questions raised about some of the structures being used. This demonstrates, at least in the sukuk market, an absence of immunity from the broader economic problems.’17 Islamic finance clearly did suffer despite the fact that its principles did in the most part protect it from the worst of the crisis and one could argue securing the attractiveness of Islamic finance for the future. Ahmed does however point out that, ‘While following the principles of Islamic finance would have prevented the crisis, there is a danger that some of the practices of Islamic finance can make the sector vulnerable to a similar episode.’18 Specifically he is talking about the trend of Islamic finance trying to mimic complex Western financing techniques which if anything should be avoided more now than ever. Conclusion The principles of Islamic finance create an approach to investment that is very different to established Western practices. Over the past three years many of the elements of the Western financial system have combined to create the credit crisis and bring into question the safety and standard of this, the primary source of global finance. The use of derivative products and the extension of loans without proper oversight were at the centre of the credit crisis but in the context of Islamic finance it has been shown that these elements either do not exist or are dealt with in very different ways. The incorporation of partnership agreements rather than simply creating derivative products to sell, provides the Islamic financial system with a far greater incentive to scrutinise borrowers and provide them with packages that insure their long term viability. This combined with the avoidance of uncertainty in financial transactions has given the Islamic financial system a high degree of protection from the credit crisis. 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