What began in the mortgage financing sector in the US has rapidly spread globally. While financial crises are not uncommon in today's world, their frequency and the extent of their damage is growing, from the savings and loans crisis in the mid-1980s, the Mexican currency crisis in 1994, the Asian currency crisis in 1997, the Russian sovereign default in 1998, the LTCM bailout in 1998, the dot-com bubble burst in 2000 and the housing bubble burst in 2006 to the commodity bubble burst in 2008. The early financial turmoil was an early sign of the bigger problems ahead.Most developed economies entered into a recession in the second half of 2008, and the economic slowdown has spread to developing countries and transition economies.
According to the International Monetary Fund (IMF), the world gross domestic product (GDP) is expected to slow to a meager 0.5 percent in 2009, the weakest pace seen since World War II, as expectations of more than $2 trillion worth of bad assets from the US affect economies from Russia to the UK.
A comparison of economic growth
Between September 2007 and October 2008, 16 banks in the US filed for bankruptcy and more than 100 out of 7,000 were on the US Federal Reserve's watch list. While this proportion is small relative to the Great Depression, when about 700 out of 9,000 banks failed, its ramifications are every bit as big.
In 2008 the Federal Housing Finance Agency placed Fannie Mae and Freddie Mac (which held about $5 trillion worth of mortgage loans, or about half of all the mortgage loans in the US) under the protection of the US government, and the US Treasury provided financial support to avoid large dislocations in the global financial system.
Lehman Brothers and Washington Mutual had to file for bankruptcy, the former being the largest firm to do so in the US, while the latter is the biggest bank ever to fail. AIG, once one of the largest insurance companies in the world rated “AAA” by both S&P and Moody's with $1 trillion in assets and operating in more than 100 countries, was bailed out by the US government.
The European financial institutions were not spared, as a large number were on the brink of collapse, such as the Dutch-Belgian bank Fortis, the French-Belgian Dexia, the British mortgage lender Bradford & Bingley, Germany's Hypo Real Estate and Dutch bank and insurance company ING.
In Iceland, four major banks collapsed, dragging the country into bankruptcy as the total external liabilities of the banks were five times Iceland's annual GDP.
Cause of the crisis
To Australian prime minister Kevin Rudd, the global economic crisis was a result of the “comprehensive failure of extreme capitalism,” and highlighted greed and fear as the “twin evils.” There is a general consensus that the financial crisis began in the mortgage financing sector of the US financial system and spread rapidly to the global financial system.
Leverage and market deregulation
The root cause of the current crisis is the unprecedented levels of leverage taken on by financial institutions, coupled with loose lending standards and market deregulation.
On April 28, 2004, the US Securities and Exchange Commission (SEC) relaxed the leverage limit for investment banks, whereby investment banks were no longer constrained by any gross leverage limit but could evaluate their assets according to their own internal models in keeping with the consideration of the Basel II accord. Further, the current practice of fractional reserve banking gives financial intermediaries the ability to create or destroy credit out of thin air.
Banks, which are generally very sensitive to changes in anticipated risks and asset prices, use the concept of value-at-risk to manage their balance sheets, which are subject to mark-to-market accounting.
The above relationship implies that as value-at-risk increases, which occurs when asset prices rise during a market uptrend, the leverage ratio declines and hence banks can increase their leverage by extending credit. This means that leverage acts procyclically and credit creation is higher when credit should contract.
The high levels of leverage enabled asset values and consumption to be raised to unsustainable levels. When sentiments finally turned, a massive deleveraging occurred. Before filing for bankruptcy in September 2008, Lehman Brothers had a leverage ratio of 30 to 1, which implies that a mere 3.3 percent drop in the value of its assets would wipe out its entire equity and make the company insolvent.
Interest-based contracts, trading of uncertainties and financial speculation
( riba, al-gharar, al-qimar and al-maysir)
The modern financial system operates overwhelmingly with interest-based debt contracts. It is argued that interest rewards no genuine sacrifice and its compounding ensures that wealth accumulation is tilted toward the renter.
The other culprit at the heart of the crisis is the unbridled trading of uncertainties and speculative transactions, particularly in financial contracts known as derivatives. American investor Warren Buffett has described derivatives as “financial weapons of mass destruction.”
Banks were allowed to allocate zero capital to loans that were hedged by derivatives called credit default swaps (CDS). Over the last 10 years, the CDS market grew unregulated from almost zero to $44 trillion (almost twice the size of the US stock market) as shown below. In spite of its potential systemic effect, the derivatives market is completely unregulated, and therefore non-transparent.
The same holds true for the securitization market, which has grown tremendously in recent years, particularly the almost $6 trillion mortgage-backed securities (MBS) market. Most of the securities were issued under the SEC rule on limited disclosure. The crisis was exacerbated by the rapid securitization of US subprime mortgage loans.
Subprime refers to a segment of the market in which mortgages were issued and credit extended to buyers with low credit scores, brief or no credit history, little or no assets, and poor income-earning prospects. These were referred to as Ninja loans: no income, no jobs, and no assets.
Banks would package these mortgages and sell them to a special-purpose vehicle, which in turn would securitize them into MBS and rearrange them to transform them into innovative instruments called collateralized debt obligation (CDO).
The proliferation of complex securities and derivatives had increased aggregate systemic risk throughout the financial system. Not only were banks and investment banks affected, but a whole range of players, including credit insurers, hedge funds and investors in asset-backed commercial paper have also suffered major losses.
Information asymmetry
(ghish and jahalah)
The lack of transparency and, hence, information asymmetry, where one party to a transaction has more information regarding the subject matter than other parties, had led to adverse selection, where transactions are conducted with inadequate information; as well as moral hazard.
Moral hazard, a concept that originated in the insurance industry, arises when the borrower seeking financing uses the funds differently than agreed upon while the financier has no control to mitigate this risk.
The inadequate assessment of risk led to unreasonable compression of credit spreads in the financial market. Assessments that were based on complex modeling did not give sufficient regard to tail risks or liquidity risk and had a heavy reliance on rating agencies.
Moody's revenue from structured credit ratings increased from a little more than $100 million in 1998 to over $800 million in 2006, representing more than 80 percent of its total revenue.
Money and the fiat money regime
In the capitalist financial system, which is based on credit and fiat money, money is a commodity that can be freely traded. Banks and financial institutions are able to sell money easily to the consumer market with methods such as subprime housing loans, personal financing and credit cards, leading to a global debt trap and bankruptcies.
The ease with which money is sold leads to inflation. Authorities will then raise interest rates to address inflation, and the corporate sector will be negatively affected as the cost of borrowing rises.
This then leads to a recession, culminating in redundancies and job cuts. Thus, in a fiat money regime, the vicious cycle of inflation and recession will always prevail.
Islamic finance is more than just about making a profit. Every investment proposition should be tested against the “Maqasid al-Shariah” (objectives of the Shariah), where the primary objective is the realization of benefit to people, concerning affairs both in this world and the hereafter.
Islam seeks to realize greater justice in human society. The financial system may be able to promote justice if, in addition to being strong and stable, it satisfies at least two conditions based on moral values:
The financier should also share the risk of financing to avoid shifting the entire loss to the entrepreneur and making unjustifiable profit without taking any risk.
An equitable share of financial resources mobilized by financial institutions should be made available for social welfare projects, such as helping eliminate poverty, expanding employment and reducing income inequalities.
Money
In Islamic finance, money is regarded as a medium of exchange and a measure of value. It is not a commodity that can be traded with interest being the price for this. Rather, money should be used to finance the legitimate trading of goods and services, and for project finance and venture capital purposes.
Hence, in Islamic finance, money becomes of real value as it drives a process of continuous value creation for the real economy.
Greater risk awareness and management
(prohibition of gharar)
In Islamic finance, a financier that shares the risk of loss would be motivated to assess risks more carefully and monitor the use of funds by the borrowers. This implies that all parties should be interested in the outcome of the underlying transaction.
One of the most important lessons to be learnt from the present crisis is that the financial sector became too removed from the real world economy.
Many financiers were very detached from the originating transactions due to activities such as securitization, repackaging of assets, utilization of CDS and over-reliance on credit rating agencies, such that the management of risks was inadequate.
Interest-based debt contracts and leverage
At its core, Islamic finance is concerned with the deployment of capital in genuine commercial activities that will benefit the community as a whole. Islamic financial techniques that are applied and executed properly create a much closer nexus between the asset, the customer and the financier.
Islamic finance prohibits the creation of debt through direct lending and borrowing, hence prohibiting excessive leverage, which is a root cause of the crisis. The creation of debt, through the sale or lease of real assets (via the Murabahah, Ijarah, Salam or Istisna modes of financing) is permitted subject to the following conditions:
The underlying assets are real and not imaginary or notional.
The seller or leaser must own the goods being sold or leased.
The transaction is genuine, with the intention of giving and taking delivery.
The debt cannot be sold and thus the risk must be borne by the financier.
These conditions help eliminate the creation of excessive leverage and ensure that transactions are related to genuine economic activities. Debt will not rise far above the real economy.
Prohibition of riba
The prohibition of riba is central to Islamic finance. An important related Shariah maxim is “al-Kharaj bid Daman,” or revenue goes with liability.
In its ideal form, Islamic finance would raise the level of equity and profit and loss sharing, which is also advocated by some mainstream economists, such as Professor Kenneth Rogoff of Harvard University, who has stated that “in an ideal world, equity lending and direct investment would play a much bigger role.”
Shariah encourages the earning of profits as it indicates successful entrepreneurship and creates additional wealth.
Prohibition of gambling and unearned income
(al-qimar and al-maysir)
The Shariah prohibition on gambling and unearned income prevents debt trading activities, speculation and use of derivatives such as CDS by parties that do not possess the underlying assets but hope to make speculative gains. Islam prohibits contracting under conditions of uncertainty (gharar) and gambling (qimar).
Islam also prohibits short selling, with certain exceptions such as Salam and Istisna, where the goods are not readily available and need to be produced before delivery. In the recent crisis, certain parties had aimed to profit from falling prices by shorting the market. This exacerbated the fall in market prices.
Equal, adequate and accurate information
(prohibition of gharar and jahalah)
One of the causes of the crisis was the excessive amount of “investments” made in the market without a deep or clear understanding of the businesses or assets that had been acquired. The asymmetry of information exacerbated the situation.
Islam attaches great importance to the role of information in the market. The release of inaccurate information is forbidden. The concealment of vital information (ghish) violates the norms and tradition of Islamic ethics, and the disadvantaged party (in terms of information) at the time of entering the contract has the option to annul the contract.
In addition, Shariah does not permit uncertainty (Gharar) or complexity in contracts, which are common for derivatives and securitized contracts.
Cooperation and solidarity
Islam encourages social cooperation and assistance. The critical situation today may have been averted if destructive activities were not undertaken by banks and other financial institutions.
In line with the Shariah, financial institutions could focus more closely on their social responsibility obligations and provide the intermediation and exchange functions needed for day-to-day trading activities; facilitate the development of society with capital supply; and provide long-term savings and retirement products needed by society.
Dedicated institutions with social objectives in line with Maqasid al-Shariah could provide microcredit financing to poor and lower-middle-class entrepreneurs on a humane, interest-free basis (qard hasan) if the system is integrated with zakat and wakaf institutions.
Conclusion
The crisis has proven that Islamic finance is a credible alternative system that is free of the major weaknesses found in the conventional system. The current crisis shows up the soundness of a trade and investment-based financial system as advocated by the Shariah. The strengths of Islamic finance are derived from its adherence to ethical finance and socially responsible investment.
This article was first published in Islamic Finance news (www.islamicfinancenews.com) in May 2009. Republished with the permission of the publisher.
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