Current Financial Crisis and the Relevance of Islamic Finance - Assignment Example

Current Financial Crisis and the Relevance of Islamic Finance Table of Contents 1. Introduction : page 3 2. Causes of current financial crisis : page 4 3. Islamic Finance Principle : page 9 4. Islamic Finance Products : page 11 5. How and why the Islamic Finance was protected from the crisis? : page 13 6. Conclusions : page 19 7. References : page 21 Introduction The recent financial crisis has proved the possible risk factors involved in the traditional financial principles and financial products. Even economic pundits or the banking experts failed to anticipate or forecast the drawbacks of the current system accurately. The current financial crisis was much deeper than anticipated and many of the developed countries like America, Britain, Canada, Australia etc are still struggling to come out from the recession problems. In fact the call for alternate financial systems and products is growing everywhere since the current system failed to live up to its reputations. The popularity of Islamic finance principles and Islamic finance products are growing across the world at present because of the belief that Islamic Finance Industry was partially protected from the current financial crises due to its principles. “The modern Islamic banking movements started as a small community fiancé effort in Egypt (1963) and grew gradually to become a small emerging fiancé in the Middle East (1973). In the early 1980’s Islamic banking came to Europe”1. The functioning of Islamic Bank of Britain (IBB) is one best example for the popularity of Islamic finance products in the European countries at present. Moreover, “India's Bombay Stock Exchange launched a share index of sharia-compliant companies in an attempt to open stock-trading to more Muslims”2. “Most readers encounter Islamic finance first through grossly simplistic statements such as Islam forbids interest”3. Perhaps the major reason which prevented Islamic finance from gaining popularity so far was the denial of interests by Islam and its financial products. It is difficult for a lay man to understand the core principles of Islamic finance unless he learns about it deeply. The banking or financial sector activities are defined in a peculiar manner by the Islamic religion based on the Shariah or the Islamic law. Shariah prohibits people or financial institutions like banks from accepting any fees as interest for the money lent by them. Islamic scholars and professionals claim that the Islamic Finance Industry is safer than the conventional fiancé industry because of the less risks associated with it. In order to discuss the above claim properly, we should first analyse the actual causes for the current financial crisis. Causes of current financial crisis The changing life styles of the people also contributed heavily to the current financial crisis. People in the developed countries normally don’t have the habit of saving money for the future. They have the habit of lavish spending and hence they may not have enough money in their pocket when they face the necessity of purchasing a home or car. These people approach the banks for loans and the banks have a habit of sanctioning loans without proper enquiries about the financial assets of the person who approached them. Such people will naturally fail to repay the loans and the end contributed heavily to the current financial crisis. The government or the agency controlling the activities of financial sector failed to monitor or control the economic activities in the financial market. Many people are of the view that the major reason for the current economic problem are because of the foolish lending habits of the banks. Banks miscalculated the global economy as a renewable source of income and took fewer precautions while lending. They thought that the global ocean of wealth will never be exhausted even though it may fluctuate or swings from one end to other. Because of the above belief, they allotted loans to most of the people who approached them, without conducting proper evaluation of the repayment abilities of the loan seekers. The greedy customers exploited the offers they received from the banks. They approached the banks whenever they were in need of big money for purchasing homes, cars etc. At the same time they showed little interest in repaying their loans and the banks did little to collect the amounts from the borrowers. Banks thought that their business will grow at rapid pace, if they were able to lend as much money at a higher interest rate. In other words, banks have given more focus to the goods or services they sold rather than the goods or services bought. They thought that selling their services at higher interest rates will always bring dividends to them. Once the balance between the services and goods sold and bought were destroyed, financial crisis came into the picture. Securitization is cited as another reason for the current financial crisis. The role of Securitization in causing financial crisis was proved beyond doubt in 20014. Many of the economic gurus are of the view that the current recession would not have happened if the securitization market had been better regulated. Before securitization came into the picture, the banks and other financial institutions assessed the repayment abilities of the loan seeker in a comprehensive manner before sanctioning the loans. However, the mortgage lenders later realized that they could sell their mortgages by converting them into securities. Thus more money started to flow across the lending market or mortgage market without proper control. The realization that the mortgages could be converted into securities and traded like stock has attracted many of the financial institutions into the mortgage market. A variety of mortgage lenders and customers started to develop in the financial market. As a result of that, getting a loan for anything was easy for the public. But the mortgage boom and increased financial activities in the mortgage market brought unexpected problems. Lenders found the demand for mortgage-backed securities was so intense they could unload just about anything — even risky, subprime debt. And because of that, lenders never had to hold the loans on their books very long — which means they didn't have to worry too much about whether the people they lent to could really pay back their loans5. Certificate Deposit Scheme (CDS) is believed to be another reason for the current financial problems. Most of the banks all over the world encourage customers to deposit in the CDS. CD is an investment option for a particular period of time as agreed by the bank and the customer. Banks will give more interests to the amounts deposited in the CDs than the amounts deposited in the normal savings accounts. Unlike savings accounts, CDs allow banks to use the money deposited in the CDS in a more profitable manner. Customers can take back the money deposited in the savings account any time they want whereas is difficult to withdraw the money deposited in the CDs before the tenure of the period. Thus, banks can use the money deposited in the CDS for a longer guaranteed period which allow them to pay more interest rates to the CDS than the normal savings schemes. Interest rates include the rate that consumers have to pay banks for loans, as well as the rates that banks will pay on savings accounts and CDs. These rates are linked, and generally rise together or fall together. Banks profit by borrowing money from consumers at one interest rate, and lending money to consumers at a higher interest rate. The profit is the difference between those interest rates. Therefore, when the lending interest rate falls, so will the interest rate paid on savings accounts and CDs. In almost all cases, the net effect of a recession on CD rates will be heavily negative. As federal interest rates are pushed down, interest rates will fall across the board in all banking products, from housing loans to savings accounts. A recession will likely keep interest rates low, on CDs and everything else, until an economic recovery begins6 “The sub-prime crisis is the result of good people getting bad loans. Loans that triple or quadruple in interest rates, riddled with small print, are unbearable by most homeowners”7. Real estate agents worked for the sellers rather than the buyers in order to maximize their commissions or profits. These agents got their commissions based on the value of the transactions they were able to execute in the real estate sector. Thus they forced even poor customers to purchase luxury villas by taking the massive amounts as loans from the banks. The lack of constraints in getting a loan from the banks forced even poor people to take big loans because of the persuasion of the real estate agents. Thus the nexus between lenders, sellers and real estate agents scammed hardworking families with the false promise of owning homes which they really couldn't afford. The words of a senior financier who is helping the Government hammer out its £500 billion bail-out plan with the British banks seem to be relevant here. "The problem with credit default swaps is people do not understand the links between the different counterparties. It is like dripping poison in the Danube and it turning up days later in the Amazon"8 The rise of petrodollars is believed to be another reason for the current financial crisis. Global financial systems are changing as a result of the growth of petrodollars (The money received by oil exporters from selling oil and their deposit into Western banks) and Sovereign Wealth Funds. Petrodollars help the Organization of Petroleum Exporting Countries (OPEC) especially the Middle Eastern Arab countries in two ways. They are not only getting good revenue by selling petroleum products in Western region at a higher margin, but also getting substantial returns on the same money deposited in the Western banks. Sovereign Wealth Funds are another option for the emerging countries to achieve more revenues from the Western countries. It is the global investment funds which make use of financial assets such as stocks, bonds, property, precious metals or other financial instruments. In short, emerging countries and their firms making lot of money from petrodollars and the Sovereign Wealth Funds invested in the Wall Street Firms. Once the Wall Street Firms suffered the impacts of financial crisis, the investors in these firms also forced to suffer a lot. The world economy is highly interconnected at present because of globalization and liberalization and hence any financial problems occurred at one corner of the globe may affect the other corner as well. Lot of companies are nowadays investing in the foreign capital markets, especially in the capital markets of the developed countries. The public have lost billions of money as a result of the share market collapse. Because of the liberalization policy adopted by most of the countries, the centralized control of the monitoring unit over the financial sector is not much effective at present. The bills or laws passed to improve liberalization policy will have negative impacts up on the monitoring units in regulating the money flow in financial sector. Thus, their efficiency and supremacy will be reduced in the money transactions in the financial sector. This will allow the banks and insurance companies to jump into the global market without proper insight or investigation about the risk factor. Islamic Finance Principle The core element of Islamic financial systems is the prohibition of interests or riba in money transactions. Islam does not allow the money lenders to charge any interests for the money they have given as loans. The major elements of Islamic finance are formulated based on the following principles; the prohibition of taking or receiving interest capital must have a social and ethical purpose beyond pure, unfettered return investments in businesses dealing with alcohol, gambling, drugs or anything else that the Shari’ah considers unlawful are deemed undesirable and prohibited a prohibition on transactions involving masir (speculation or gambling) and prohibition on gharar, or uncertainty about the subject-matter and terms of contracts – this includes a prohibition on selling something that one does not own9 Islamic banks can obtain their earnings only through profit-sharing investments or fee-based returns since taking interests from the money borrowers is prohibited in Islam. In other words, both the lender and the borrower should share the risk associated with a money transaction. For example, consider an entrepreneur has taken a big amount from a bank for his business purpose. If he loses his money in business, the bank cannot ask him to repay the entire money he borrowed. In other words, the losses of the entrepreneur may become the losses of the bank or the lender also. The money transactions in conventional financial markets and Islamic financial systems can be better understood using the illustrations given below. Juristic characteristics of mortgage loan Financial institution (mortgagee) $ mortgage Lien on payments property + $ $ mortgage amount according to Loan amortization schedule document $$ home price Home buyer (mortgagor) Home seller (clean title) Title Murabaha alternative for home finance Financial institution (mortgagee) $ mortgage $$ payments down payments $ $ mortgage amount according to +Islamic $$home price title amortization schedule mortgage documents + lien on property Home buyer (mortgagor) Home seller (clean title)10 From the above illustrations, it is clear that in traditional lending business, the mortgagor borrows loan from the mortgagee and promised to pay a larger amount of money in future. In other words this type of loans is interest bearing loans of money. “B separating the loans from the sale contract for which it was intended jurists equally condemn secured loans (mortgages) and unsecured loans (credit balances). In murabaha transactions the mortgagee must first purchase property from the seller. Then the bank may turn around and sell the property on credit to the mortgagor using amortization tables that are often calculated on the same interest rate used for conventional mortgages. The difference is that the mortgagor in this case is involved in credit sale contract rather than a loan contract11 Islamic Finance Products Ijarah or leasing, Islamic funds, Sukuk or the Islamic bonds, and the Takaful or the Islamic insurance etc are some of the Islamic finance products. Sukuk is a financial certificate in Islamic finance just like a conventional bond. Sukuk bonds are different from the conventional bonds. “In Sukuk an investor gets returns on the basis of ownership rather than the interests”12. Sukuk offers fixed returns to the investors whereas in conventional bonds, the returns are not fixed for the investors. Conventional bonds and its returns is always dependant on the market conditions. In conventional bonds, when the market grows, the investors will get more money whereas when the market collapses, the investors may lose money. Sukuk invest in assets whereas traditional bonds invest in currencies. The return from assets may be in the form of rent in Sukuk investment. Takaful is an alternative to conventional insurance in Islamic finance13. As in the case of other financial products, insurance activities are also have special characteristics in Islamic finance. Takaful come into existence among Islamic community around thousand years before. Shared responsibility is the core of Takaful insurance products. Takaful policy holders have better cooperation in between them for the common good. Takaful policy holders pay their subscription to assist others who are in need. Losses and liabilities of all the policy holders of Takaful will be divided equally among the policy holders. In short Takaful is a form of insurance based on cooperation. Conventional insurance don’t have such cooperation among the policy holders. In conventional insurance, policy holders may not have any responsibility to help each other. “The current Takaful practice uses a combination of two types of ‘Aqad (contract). These are the Tabarru' (donation) and Mudharabah (investment) contracts which are free from the elements of Riba (interest), Maisir (gambling) and Gharar (uncertainty)”14. One of the major differences between the takaful insurance products and the conventional insurance products is the cost factor. Takaful products are more expensive compared to traditional insurance products. Nonexistence or retakaful arrangements in the market; lack of product flexibility in terms and conditions; hidden agendas; unattractive investment programmes etc are some of the other challenges faced by the Takaful products or Islamic insurances in the market at present15. Equity funds, real estate funds, hedge funds etc are some of the examples of Islamic funds. “The first Islamic equity fund was the Amana Income Fund, established in June 1986 by members of the North American Islamic Trust (NAIT), an organization based in Indiana which oversees the funding of mosques in America among other things. Mendaki Growth Fund, Singapore (5/91), Southern Pure Specialist Fund, South Africa (6/92), Al Rajhi Local Share Fund, Saudi Arabia (7/92),Tabung Ittikal Arab-Malaysian, Malaysia (1/93) etc are some of the major funds came into exist in the 1990’s16 How and why the Islamic Finance was protected from the crisis? “Islamic finance forges a closer link between real economic activity that creates value and financial activity that facilitates it. Islamic finance does not allow creating new risks to profit thereby”17. The prevention of interests in Islamic finance will discourage the lenders from giving loans to anybody who approaches them. In other words, the banks would be forced to investigate more about the financial capabilities of the loan seeker since they are also liable or accountable for the money spent by the borrower. The banks will put more control over the transactions or economic activities using the money they paid to the borrower. In short, the borrowers will be forced to take permissions from the banks before spending the money in a particular way. Thus, the number of non-genuine borrowers approaching the banks for loans will be considerably reduced in the case of Islamic banking. At the same time, such tight control over the money sanctioned as loans will reduce the economic activities up to certain extent which is not good for the rapid progress of a country. The availability of easy money or loans will help the buyers more in purchasing goods which will increase the demand in a country. The increased demand will result in increased production which is desirable for the proper economic growth of a country. In short, tight control or supervision of loans will distance the borrowers from the banks and in all probabilities the economic activities would be considerably reduced even though more control of money transactions are there. “The most common Sukuk structure involves selling property and leasing it back”18. Even though many people criticize Sukuk like Islamic financial products, many others are in favour of it because of the tight control it provides to the money transactions. Financial institutions across the world are at present trying to implement Islamic financial products, considering the control it provides to the lenders. The claims involved in Sukuk bonds are not limited to cash flow alone as in conventional bonds, but it can claim the ownership as well. The commitment of the governments in helping each other in countries where Islamic finance is prevailing is more evident nowadays. The financial crisis occurred to one of the biggest companies in the world, Dubai world and the readiness of the Abu Dhabi government in helping Dubai government and its companies to overcome the current crisis are better examples of the cooperation among the Islamic world in overcoming financial problems. In fact Dubai was the number one competitor for Abu Dhabi and even then Abu Dhabi shown no hesitation in helping Dubai to come out from the current crisis which is impossible to witness anywhere in the world. “Property developer Nakheel said that it will meet its 2009 Islamic bond obligations in the next 14 days, averting default after the Abu Dhabi government stepped in with a bailout”19. Nakheel was in trouble recently and it created immense fears among the investors because of the recent Dubai financial crisis. But Abu Dhabi stepped in for helping the Dubai world and Nakheel which helped them to overcome the current crisis. The popularity of the Islamic financial products across the world at present encourages Islamic countries more in spreading their financial systems at present. Earlier, nobody cared much about the Islamic banking system because of the misconceptions about Islam and its adamant adherence to the fundamental values of their religion. Perhaps, Islam is the only religion which fought successfully against the rapid changes happening in the living styles of the people across the world. Reformers labelled Muslims as fundamentalists and their concepts and principles in the financial sector were neglected by the rest of the world. However, the recent recession forced the world to explore more positively about the core Islamic financial principles and its applicability in the present world. Saudi-based Islamic Development Bank (IDB) plans to issue Islamic bonds (sukuk), in the first half of 2010 worth around $850 million, a senior official said on Thursday. In September IDB, the Saudi based triple-A lender, which funds projects in Muslim member countries, sold the first tranche of a $1.5 billion sukuk, a $850 million sukuk which was priced at 40 basis points over mid-swaps20 Leasing is another area in which Islamic leasing (Ijarah) differs with conventional leasing. Conventional leasing is a contract in which asset is transferred to users for an agreed period on an agreed consideration. It is not necessary that a person have to own a property in order to enjoy the benefit of conventional leasing. Ijarah on the other hand is a lease contract as well as a hire contract21. In normal leasing, the lesser will give his property or equipments to the lessee for an agreed period of time on a monthly or annual rental basis. The lesser will not have any claim on the profit earned by the lessee. The lessee should pay the agreed amount monthly or annually to the lesser irrespective of profits or loss he suffered. In conventional leasing the ownership of the property or equipment leased would be transferred to the lessee till the end of the leasing period. The lessee should do all the maintenance and repairs needed for the property during the leasing period. “On the other hand, Ijarah refers to the transfer of usufruct of asset against the payment of rent”22. The legal right to use and derive profit from a property belongs to another person, as long as the property is not damaged in Islamic leasing. In Ijarah, the ownership of the leased asset does not transfer under any circumstances. In other words, the ownership of the leased property in Ijarah would belong to the lesser always even though the lessee is making profit out of it. Thus, Ijarah provides more control to the lesser over the lessee compared to the traditional leasing transactions. In case of any debt created by trade or Ijarah transactions, banks are not allowed to charge anything over and above the principal amount23. Only the principal amount is guaranteed to the lesser in Ijarah transaction even if the debt of the lessee is more than the principal amount. Ijarah advocates the affordable instalment procedures in purchasing activities. In other words, Ijarah is worked on humanitarian principles and it does not like to impose heavy burdens on the lessee. On the other hand in traditional leasing, such humanitarian considerations will not be there and the lessee should pay the agreed amount to the lesser even if he losses in his business using the property of the lesser. Ijarah is the most suitable mean to raise investment funds to industries where rapid technological innovation is taking place. The major advantage of Ijarah over conventional leasing is that the asset remains with the lesser always24 Islam allows people to invest in stocks only if the investments made on stocks obey the rules of Shariah. The earnings obtained from the stock investment will be considered as halal or legitimate by Islam only if the investor invests in a halal company. Shariah laws believe that once an investor invests in a stock, he is becoming the part of the company. In other words, the investor has the moral responsibilities in the actions of the company. Hence the investor should invest only in legitimate companies. Thus investing in illegal or illegitimate companies is prohibited by the Shariah laws which will help the growth of only the legitimate companies in a country. In short, Islamic methods of investments in stocks will never encourage unethical companies to prosper in a country. Generally, the investor should make sure that the company he opted to invest does not make any income from interests. “However looking at the current situation shariah scholars have permitted to invest in stocks of companies whose income from interest forms less than 5% of a company’s total income. Some scholars have fixed that ceiling at 10% of a company’s total income”25 Margin trading is another activity which is controlled by the Shariah laws. In most of the cases, the money used for margin trading is loaned from the broker, for which interest needed to be paid. “From shariah point of view, you cannot sell what you do not posses and hence short selling is also prohibited as per the Sharah laws”26. In normal share markets activities, short selling is a common activity which helps people to make profits even if they may not have money to purchase shares. Short selling is the selling of a stock that the seller doesn't own. More specifically, a short sale is the sale of a security that isn't owned by the seller, but that is promised to be delivered. When using a broker, you will need to set up an account. The account that's set up is either a cash account or a margin account. A cash account requires that you pay for your stock when you make the purchase, but with a margin account the broker lends you a portion of the funds at the time of purchase and the security acts as collateral27. The possibility of short selling often encourages investors to purchase more shares in anticipation that the share prices may go high in future. If their anticipations or calculations went wrong, they may suffer lot of losses. In other words, short selling encourages investors to take risk. Islam does not allow margin trading or short selling which means more stability will be there in the stock markets. “Ability to operate as an integral part of the international financial system’ and ‘developing a sound and stable regulatory regime’ are the two fundamental challenges to be addressed by the Islamic Financial Institutions”28. Since no penalties or interests were imposed on late payments, loan takers will take their own time for the repayment of loans Risk Management Regulatory & Disclosure Conclusions It is a fact that the current financial systems have lot of loop holes which affects in the money transactions in the financial market. The lending habits of the financial institutions were motivated only by the profit making mottos which often create more problems not only to these institutions, but also to the investors and the general public. The recent recession is believed to be the contribution of the banking sector, insurance sector and the stock markets collectively. Many of the countries put less control over the activities of these financial institutions in an effort to encourage the economic activities and to grow their economies rapidly. However, they failed to anticipate the problems in doing so and the result was severe recession at an unexpected time. Putting more control over the financial institutions is the only way to avoid such recession in future. Most of the countries are at present seeking alternate options in regulating the activities of their financial sector and Islamic financial system seems to be an option available at present. Islamic financial products and institutions are totally different from the traditional financial products and institutions. It is totally based on the Shariah laws and hence unethical business habits were prohibited strictly. Interests earned on the capital makes the people and the financial institutions to act unethically while doing business in financial market. Islamic financial systems prohibits the concept of interests and hence the banks will never try to lend as much as money possible without assessing the financial capabilities of the borrower. The absence of interest system will force the banks to tighten their norms for giving loans and hence only the genuine borrowers will approach the banks for loans. Islamic financial systems regulate or prohibit the unethical business behaviours like margin trading, short selling etc and hence the stability of the stock markets will increase more. Cooperation among different stakeholders in the financial market is more in Islamic finance system and the risk associated with a money transaction is shared equally by the stakeholders. Critics of Islamic finance system are of the view that, the tight regulations on the finance sector will decrease the economic activities and hence the progress of a country will be retarded if such a system is implemented in a country. However, considering the advantages and disadvantage of Islamic financial systems and the depth of current financial crisis, it is better to make use of Islamic systems in a polished or customized manner. In other words, Islamic financial systems refined or restructured in a particular way to suit the needs of a country (customization) would be a definite answer to the current problems in the finance sector. References 1. Ayub M. (2008). Understanding Islamic Finance, Publisher: Wiley (January 2, 2008) 2. Al-Rifai Tariq, (1999), Islamic Equity Funds, [Online], available at: http://www.kantakji.com/fiqh/Files/Markets/30031.pdf [Accessed on 31 December 2010] 3. 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