Would Islamic finance have prevented the current global financial crisis Discuss - Essay Example

?Would Islamic Finance have Prevented the Current Global Financial Crisis? By Islamic financial institutions in the Gulf Corporate Council (GCC) states performed relatively well during the global economic crisis of 2008-2009.1 The successful performance of Islamic financial institutions in the GCC states is attributed to sustained growth, a conservative prudential regulatory framework and the implementation of fundamental Islamic ideology.2 It has been argued that the primary cause of the 2008-2009 global financial crisis was a lack of discipline in the market which essentially gave way to high risk behaviour culminating in a crisis of unprecedented proportions. The Islamic financial markets appears to have greater discipline and risk-sharing and conceivably can provide a solution or safeguard against the risk of financial crises.3 This research study analyzes the possibility that a world financial system modeled after Islamic financial systems may have prevented the current financial global crisis. It is concluded that some aspects of the Islamic financial markets system may have functioned to minimize the current global financial crisis, but it could not have prevented the crisis altogether. This is because some features of conventional financial systems are necessary for preserving and servicing conventional financial needs and competition, particularly the interests rates attributed to mortgages. This paper is therefore divided into four sections. The first section analyzes the causes of the financial crisis of 2008-2009. The second part of this paper analyzes the key aspects of Islamic financial markets regulations and ideologies. The second part of this paper also identifies and strengths and weaknesses of Islamic financial systems. The third part of this paper analyzes the feasibility of Islamic financial systems as a solution to or safeguard against financial crises. The final part of this paper offers concluding remarks and observations. Contents Abstract 2 Contents 3 Introduction 4 The Causes of the Global Financial Crisis 2008-2009 5 Islamic Financial System: Strengths and Weaknesses 9 The Islamic Financial System a Model Capable of Preventing the Global Financial Crisis 15 Conclusion 18 Bibliography 19 Introduction The 2008-2009 global financial crisis has been described as the world’s most devastating financial crisis surpassing the severity of the Great Depression of the 1930s.4 The severity of the most recent global financial crisis has called into the question the foundational basis of the capitalist financial system and economist are steadfastly committed to finding solutions to the exposes weaknesses of the conventional capitalist system and safeguarding against another global financial crisis.5 The socio-economic justice inherent in the Islamic financial system which safeguards against future debts is said to be the most important feature of Islamic financial systems and largely protected it from the severity of the current global financial crisis.6 While the Islamic financial system served to largely protect Islamic finance from the devastating consequences of the recent global financial crisis, the main question is whether or not a system modeled after Islamic finance can safeguard against a financial crisis in conventional capitalist financial systems. This paper evaluates Islamic financial systems and concludes that some aspects of the Islamic financial systems may minimize the risks of financial crises but would not prevent a crisis altogether. This research study will therefore evaluate the causes of the financial crisis of 2008-2009 and will evaluate the main features of Islamic financial systems and its future projector. By taking this approach, this paper will be able to identify the strengths and weaknesses of the Islamic financial system and its applicability and compatibility with conventional capitalist financial systems. The Causes of the Global Financial Crisis 2008-2009 The United Nations reports that the US property bubble burst in 2008 set off the ensuing global financial crisis. The property bubble burst resulted in defaults in mortgage obligations, which set off a series of events bringing about severe damages to banking sectors and financial markets globally. For the most part, banks were severely harmed by no-performing loans or complex financial assets attached to default loans. This set off a chain reaction in which confidence was frayed in the stability and solvency of financial institutions. What followed was a severe credit crunch that impacted the real economy globally.7 Crotty maintains that the recent global financial crisis is a natural evolution of the capitalist financial market which focuses on a process of “financial deregulation” which started in the 1970s.8 According to Crotty, this process encapsulates deregulation which co-exist with “rapid financial innovation” stimulating “powerful financial booms that end in crises”.9 Governments typically respond by bailing out failed financial institutions so that they may expand yet again. The result is, financial markets have grown exponentially and financial crises have become more devastating. Governments are therefore compelled to make unprecedented bail-outs. As Crotty maintains: This process culminated in the current global financial crisis, which is so deeply rooted that even unprecedented interventions by affected governments have, thus far, failed to contain it.10 In other words, the conventional capitalist financial sector regulation and constructs are designed to support expansion and at the same time can by its very nature bring about massive failures. In this regard, there is little doubt that conventional capitalist financial structures are flawed. The recent global financial crisis exposed the “inadequacies of the contemporary model of financial regulation” both nationally and globally.11 The cause of the global financial crisis has been narrowed down to the sub-prime mortgage sector in the US. It has been argued that in the US, ratings and securitization processes were unable to effectively identify and respond to risk-taking excesses. In Europe, loosely regulated financial transaction such as hedge funds and private equities only added to the credit crunch that emanated from the US.12 In the final analysis, it has been ultimately determined that the structural weakness in conventional capitalist financial markets facilitated greed which permitted “powerful elites” to overreach “in good times” and take “too many risks”.13 It therefore follows that there are several causes of the recent global financial crisis, each of which are deeply entrenched in conventional capitalist ideology and its accompanying constructs. Individuals and institutions alike were complicit in the recent global financial crisis. Governments encouraged risky mortgages while US president George W. Bush implemented a tax cut benefitting the wealthy and thus lowering interest rates. Each of these factors contributed to the bubble which is needed for economic stimulation. Institutions such as the Securities Exchange Control and the Federal Reserve, mortgage companies and government administrators persevered in the drive for deregulation of the financial sector. There was a systematic failure in handling and managing interest rates and the availability of credit.14 The conventional capitalist financial market system supports the pursuit of “self-interest”. 15 Friedman et al observes that: Closely tied to the pursuit of self-interest is the belief that free markets do not need regulation.16 In this regard, “watchmen and gatekeepers” such as company executives, banks, regulators, accountants, auditors and the like “have fallen into the self-interest trap” and have largely ignored the “needs of the public”.17 Self-interest and loose regulatory practices began to reveal its flaws in 2006 when there was a shift in the US housing market. Several mortgages earmarked for segment of the market (subprime mortgages) were built around a balloon interest rate repayment which implied that the mortgage would eventually be subject to refinancing so as to offset a mortgage rate jump. This process operated on the presumption that the prices of homes would not depreciate. Beginning in 2006 however, this presumption would prove false as Ownit Mortgage Solutions went bankrupt followed by the collapse of New Century Financial, the US’s second-largest subprime mortgage broker.18 The failure of the subprime mortgage market set off a chain reaction. In June 2007, two Bear Stearns hedge funds that were invested in the securities backing subprime mortgages collapsed. Essentially, what happened was that the price of securitized debts began to drop as subprime mortgage defaults accelerated and lenders began to insist on more collateral. Merrill Lynch repossessed US$800 million in securitized assets and attempted to sell them off by virtue of auctions. With the ability to only sell off US$100 million, the decline in the value of the securitized assets began to become a more glaring reality.19 Freidman et al explain that these events are demonstrative of: The features that typify financial crises – a credit boom (which leads to the leveraging of financial institutions, in this case, the Bear Stearns hedge funds) and an asset bubble (which increases the probability of a large price shock, in this case, the housing market). Eventually, when shocks lead to a bursting of the asset bubble (i.e., the fall in house prices) and trigger a process of deleveraging, these unsustainable asset bubbles and credit booms go bust with three consequences.20 The first consequence is the decline in the value of assets that are backed by leverage which gives way to “margin calls” that compels the sale of the asset.21Secondly, with the decline in the value of assets, collateral value originally leveraged also declines. Thirdly, “margin calls and the forced file sale of the asset” has the potential to influence the decline of its prices to levels lower that its “now fundamental value” with the result that there is a “cascading vicious circle of failing asset prices, margin calls, fire sales, deleveraging, and further asset price deflation.”22 In the final analysis, excessive risk-taking, facilitated by poor regulatory and monitoring frameworks gave way to the recent global financial crisis. Such practices are not conducive to Sharia-compliant financial market constructs and systems. It therefore makes sense to examine the nature and structure of Islamic financial systems and to identify its weaknesses and strengths. By taking this approach, it can be determined whether or not the Islamic financial system structures and ideologies can provide a model for the prevention of financial crises in conventional capitalist financial markets. Islamic Financial System: Strengths and Weaknesses The Shariah which is informed by the Holy Quran provides the fundamental basis of the Islamic financial system’s regulatory framework. The Shariah regulates all aspects of the life of Muslims including, culture, politics, religion, economics and social aspects. Guided by the rules and ideologies implicit in the Shariah, Islamic financial systems prohibit interest which is referred to as riba. According to the Shariah, riba means excesses and is constructed to refer to “any unjustifiable increase of capital whether in loans or sales”.23 Riba essentially applies to any “positive, predetermined rate” connected to the final principal irrespective of its performance.24 Such a fixture is banned as riba. Generally, Islamic academics regard riba as a usury and as an interest charge.25 Riba is prohibited on the basis of Islamic ideologies relative to social justice and the pursuit of equity. Iqbal explains that Islamic principles are not against earning a profit, but it does not support: The charging of interest because profits, determined ex past, symbolize successful entrepreneurship and creation of additional wealth whereas interest, determined ex ante, is a cost that is accrued irrespective of the outcome of business operations and may not create wealth if there are business losses.26 The ends of social justice require that both the borrower and the lender equally benefit from the gains and the losses in a manner that is equitable. Moreover, the accumulation and allocation of wealth must be fair and reflective of genuine “productivity”.27 The prohibition of riba is guided by the social justice paradigm that encourages risk and profit sharing between the lender and the borrower. The basis of risk and profit sharing is that the lender will share profits and losses with the borrower.28 Thus, lenders who furnish funds to borrowers become investors so that rewards are only realized when loans perform satisfactorily.29 The strengths of the prohibition against riba is immediately obvious. This prohibition impacts the financial sector in a way that avoids a majority of the difficulties experienced by conventional capitalist financial systems that gave way to the recent global financial crisis. Implicitly, the prohibition of riba means a ban on “pure debt security” and “ultimately” a ban on “leverage through debt”.30 Even so there are some practical difficulties with the prohibition against riba. Conceivably the prohibition against riba has the potential to create an excess of demands for loans over the supply of lending facilities. In addition, savings can suffer with the result that investment and growth would become stagnant. Monetary policies would be non-existent as there would be no need to manage liquid instruments in the absence of a “fixed, predetermined rate of interest”.31There is also the risk of one-sided flight of capital in financial systems that prohibit riba.32 Despite the perceived weaknesses of the prohibition against riba, the Islamic financial sector and its relative success demonstrates that these weaknesses need not come to fruition. The Islamic financial system indeed proves that a zero rate of interest is not a compulsory feature for successful financial sector. The absence of an interest rate does not automatically mean that there is no capital or that capital will decline. Indeed, Islamic financial systems call for capital returns to be ascertained on an ex post basis and the returns are ascertained by virtue of the return applicable to economic transactions in relation to the use of the funds. It is the anticipated return on capital that characterizes the investment. It is also the anticipated return rate on the capital and its income that ascertained and directed savings. It is therefore incorrect to assume that in a zero interest financial system investments and savings would be non-existent. In addition, monetary policies would be no different than monetary policies in conventional capitalist financial systems. Monetary policies would be centred round the instruments that manage and regulate liquidity. Last, but not least, Islamic financial institutions demonstrate that in the absence of interest rates determined ex ante, but rather on the basis of returns on investments ascertained ex past, there is no appreciable risks of capital flight. Nevertheless, interest rates serve significant regulatory and management purposes in financial sectors. They influence and manage exchange rates, determine purchasing power, control borrowing excesses and can encourage savings over borrowing.33 From the perspective of Islamic financial systems however, risk and profit sharing encapsulates the view that those providing the funds agree to share risk and profits. In the event the borrower does not make any profits, the lender will retain the capital. If the borrower suffers a loss, the losses are shared by the lender. This is efficient because it ensures that funds are distributed on the basis of anticipated profits and productivity of the project funded. This system therefore encourages borrowers to invest in profitable and high productivity projects.34 Essentially, the absence of interest in the Islamic financial system positions Islamic financial institutions as capital venture constructs. These quasi-capital venture constructs lend funds on the basis of profit and risk sharing to those who have “economically promising ideas, rather than simply to established entrepreneurs with plenty of collateral”.35 More importantly, interest rates in capitalist systems of finance, by shifting risk away from lenders, encouraged greater risk taking and thus gave way to bad and underperforming loans. Complicating matters, the borrower with the prospect of repaying the entire capital and the interest rates attached, were less compelled to satisfy loans in circumstances were productivity was low and income was declining. A zero interest rate encourages attention to profitability and productivity which can only be good for economic growth and development. More importantly, in the absence of interest rates, lenders are more apt to be conservative and rational about extending loans. However, in the case of home loans as opposed to loans for projects, interest rates may provide the only incentive for financial institutions to offer loans. Otherwise, lending institutions would simply extend loans with no profitability and in many cases loans would be extended at a loss. Lending institutions would merely provide funds and expect to have the funds repaid while paying staff to manage loans with no means of an income. Moreover, even with the funding of projects, there are no guarantees that the borrower would deposit profits in the institution providing the capital. In this regard, interest rates provide the only means by which a financial institution can be assured that it will share the profits of successful capital venture. It therefore follows that while the absence of an ex ante interest rate works well for the Islamic financial system, it will not necessarily work for conventional capitalist financial markets unless, profits are reported to and deposited in the financial institution providing the capital for a project. The prohibition against speculative conduct is more instructive and certain than the prohibition against interest in the Islamic financial sector. In the Islamic financial markets all trading and business transactions are required to be productive and socially consistent with the Shariah. As a result, speculative conduct is prohibited.36 Thus, behavior that is tantamount to “hoarding” and “transactions featuring extreme uncertainties, gambling and risks” are prohibited in Islamic financial institutions.37 The prohibition against speculative conduct is founded on the Islamic principle of Gharar which translates to mean “uncertainty, risk or speculation”.38 Therefore any transaction that is characterized by gharar is forbidden in the Islamic financial system. All parties to a financial transaction should be adequately informed of the value and risks anticipated as result of the underlying financial transactions.39 The prohibition of gharar is based on the desire to protect the weak from exploitation by the strong.40 The prohibition against gharar and speculative behaviour however can be problematic for conventional capitalist financial systems for two main reasons. First, it permits too much government intervention into the financial affairs of private individuals. Liberal societies such as those found in capitalist societies are structured around the concept that the individual may do as he or she wishes with his or her property without fear of excessive government intervention. The prohibition against gharar and speculative behaviour invites government intervention to the point where private individuals are told what they can and cannot do with their own property.41 Moreover, the strict application of the prohibition against gharar means that no account will be taking of the unknown gains and losses. The result is, there will be no taking into consideration the adjustment of the obligation to repay a loan on the basis of unforeseen inflation.42 Thus, if the idea behind the prohibition of gharar is to safeguard against the risk of exploitation of the weak by the strong, the prohibition of gharar appears to facilitate the opposite outcome. If adjustments cannot be made for unforeseen inflation, the weak will be compelled to repay a loan on the initial terms despite inflation. The Islamic Financial System a Model Capable of Preventing the Global Financial Crisis At its core, the Islamic financial system capitalizes on the Islamic social justice concepts which are consistent with the zahah which translate to mean the giving of alms. Zakah in turn means purifying/cleansing and represent one of the key tenets of Islam. Zakah seeks to facilitate equity by the just distribution of the wealth. In this regard wealth is transferred from the wealthy to the poor. Thus greed and selfishness are discouraged. Likewise, the proliferation of behaviour that facilitates debt, particularly among the poor is forbidden. Moreover, Islamic financial systems are guided by the belief that debt is a major cause of poverty and financial failure in financial institutions.43 Guided by the principles of social justice and the Zakah, Islamic financial institutions are against the lending of money to persons who cannot repay the loan or those who cannot turn a profit on a new or expanded or ongoing project.44 Thus, Islamic financial institutions take a more conservative approach to lending and focus on safeguarding against self-interest and greed. Taking into account the fact that the subprime mortgage was the root cause of the recent global financial crisis, this aspect of Islamic financial market regulations is entirely feasible as a model that could have prevented and may prevent a similar global financial crisis in the future. The nature of subprime mortgages in the US was such that it permitted loans with high interest rates to individuals who were not qualified to repay those loans and to satisfy the high interest rates. Moreover, driven by self-interest and greed, realtors and banks worked together to complete subprime mortgages in circumstances where banks hoped to turn over a huge profit from the applicable high interest rates and realties benefitted from the sale of the properties to the individuals who mortgaged the properties to banks.45 Providing loans with unusually high interest rates to individuals who would not otherwise qualify for a loan was entirely unnecessary. In the end it played out as one would expect in circumstances where a loan and its high interest rate will not likely be repaid. Many of the loans were defaulted and lenders attempted to sell of the securitized collateral and in doing so the collateral was sold off at losses, if they were sold at all. The end result was a national financial crisis that transcended borders and eventually created a global financial crisis. Had the financial sector in the US and other capitalist markets adopted a conservative approach to financial systems and promoted the idea that debt created poverty, subprime mortgages would have been avoided and thus the global financial crisis would have likewise been avoided. The financial sector plays a very significant role in the real economy because it accommodates savings and “allocates credit across space and time”.46 Financial institutions make provision for “payment services” and products that allow businesses and individual households to cope with the uncertainties implicit in the economy by “hedging, pooling, sharing, and pricing risks”.47 Ultimately, the financial sector serves to reduce: the cost and risk of producing and trading goods and services and thus makes an important contribution to raising standards of living.48 Researchers generally argue that when there is instability within the financial services, the real economy will suffer because financial services and institutions facilitate the allocation of credit and savings. Moreover, unstable institutions are typically characterized as institutions that take unrestrained risks, are poorly managed/governed, have poor macroeconomic policies, are poorly supervised or any combination of each of these factors.49 In this regard, it might not matter whether or not the ideology of the financial institution is aligned with Islamic principles of social justice since corporate governance appears to be the main problem that led to the financial crisis. It was poor safeguards against excessive risk-taking, poor supervision and poor management rather than poor policies and ideologies that gave rise to the failed subprime mortgages. It therefore follows that while an ideology against excessive risk taking and the creation of unserviceable debt as practiced in Islamic financial institutions could safeguard against financial crises, it will not remove them altogether unless, good corporate governance constructs are implemented. Conclusion While the prohibition against riba and speculative behaviour have worked well for the Islamic financial system, it is unlikely to have an appreciable effect against global financial crises. The main problem appears to be in a practice conducive to self-interest an greed. The solution in liberal capitalist financial markets would be for improved corporate governance constructs and accountability. This is because any constraints on the freedom to do as one likes with one’s money and property could lead to a social and political crisis which would in turn lead to a financial crisis. The prohibition on riba would also fail to prevent a financial crisis because interest is deeply entrenched in the conventional financial systems. Individuals, businesses and financial institutions have already become accustomed to having savings accumulate interests and that interest will be applied to any sums extended by way of loan. Interest rates are necessary for restraining spending and thus the depletion of or flight of capital. Thus, interest rates are necessary for recovery from the recent financial crisis. As we have seen, there are several risks associated with relying only on profits as a means of sharing profit and losses. These risks involve an unwillingness of financial institutions to extend credit and a high demand for credit from society. These tensions in a liberal society could lead to a socio-political crisis which could lead to another financial crisis. Bibliography Textbooks Friedman, Jeffrey. What Caused the Financial Crisis. (Philadelphia, PA: University of Pennsylvania Press, 2010). Iqbal, Munawar and Llewellyn, David T. Islamic Banking and Finance: New Perspectives on Profit-Sharing and Risk. (Glos, UK: Edward Elgar Publishing, 2002). Iqbal, Zamir and Mirakhor, Abbas. Islamic Finance: Theory and Practice. (Hoboken, NJ: John Wiley and Sons, 2011). Kettell, Brian, B. 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