Islamic Banking System

An Answer to the Global Financial Crisis

Dr.Imamul Haq & Fayaz Ahmad Lone, Aligarh Muslim University, India
© Islamic Finance Today

Present Crisis:
As we all know, the present global financial crisis primarily arose as a result of the subprime mortgage crisis of the preceding period. Many USA mortgages issued in recent years were made to subprime borrowers, defined as those with lesser ability to repay the loan based on various criteria.

The crisis began with the bursting of the United States housing bubble and high default rates on “subprime” and adjustable rate mortgages (ARM), beginning in approximately 2005–2006. Government policies and competitive pressures for several years prior to the crisis encouraged higher risk lending practices. Further, an increase in loan incentives such as easy initial terms and a long-term trend of rising housing prices had encouraged borrowers to assume difficult mortgages in the belief they would be able to quickly refinance at more favourable terms. However, once interest rates began to rise and housing prices started to drop moderately in 2006–2007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity increased dramatically as easy initial terms expired, home prices failed to go up as anticipated, and ARM interest rates reset higher. Foreclosures accelerated in the United States in late 2006 and triggered a global financial crisis through 2007 and 2008. During 2007, nearly 1.3 million U.S. housing properties were subject to foreclosure activity, up 79% from 2006.

Financial products called mortgage-backed securities (MBS), which derive their value from mortgage payments and housing prices, had enabled financial institutions and investors around the world to invest in the U.S. housing market. Major banks and financial institutions had borrowed and invested heavily in MBS and reported losses of approximately US$435 billion as of 17 July 2008. The liquidity and solvency concerns regarding key financial institutions drove central banks to take action to provide funds to banks to encourage lending to worthy borrowers and to restore faith in the commercial paper markets, which are integral to funding business operations. Governments also bailed out key financial institutions, assuming significant additional financial commitments.

The risks to the broader economy created by the housing market downturn and subsequent financial market crisis were primary factors in several decisions by central banks around the world to cut interest rates and governments to implement economic stimulus packages. These actions were designed to stimulate economic growth and inspire confidence in the financial markets. Effects on global stock markets due to the crisis have been dramatic. Between 1 January and 11 October 2008, owners of stocks in U.S. corporations had suffered about $8 trillion in losses, as their holdings declined in value from $20 trillion to $12 trillion. Losses in other countries have averaged about 40%. Losses in the stock markets and housing value declines placed further downward pressure on consumer spending, a key economic engine. Leaders of the larger developed and emerging nations met in November 2008 to formulate strategies for addressing the crisis.                 

In subprime, financial institutions provided credit to borrowers who did not meet prime underwriting guidelines. Subprime borrowers have a heightened perceived risk of default, such as those who have a history of loan delinquency or default, those with a recorded bankruptcy, or those with limited debt experience.

Causes of Financial Crisis:

1.    Boom and Bust in the Housing Market. –

a.    Easy access to credit: Falling interest rates and rising availability of mortgages, combined with rising housing prices encouraged consumers to buy homes.

b. Relaxed lending standards: To cater to the growing number of mortgage seekers, lenders relaxed standards and issued a large number of sub-prime loans.

c.    Inadequate regulations: Regulations did not keep pace with innovations in US financial products, leading to much higher complexity, poor transparency and greater risk.

d.    Complex credit derivatives: The invention and use of complex debt derivatives such as CDOs made it difficult to identify and contain the sub-prime lending problem, once default rates began to rise.

e.    Market collapse: The property boom led to an over-supply of housing and prices could no longer be supported. Just like the self-perpetuating behaviour that led to the rise, the crash was also self-perpetuating. As prices fell, more foreclosures started taking place, increasing the supply of homes on the market. Lenders started to tighten their standards and fewer consumers could qualify for mortgages and help reduce the supply.

2. Speculation:
Speculation in residential real estate has been a contributing factor. During 2006, 22% of homes purchased (1.65 million units) were for investment purposes, with an additional 14% (1.07 million units) purchased as vacation homes. During 2005, these figures were 28% and 12%, respectively. In other words, a record level of nearly 40% of homes purchases were not intended as primary residences. David Lereah, NAR’s chief economist at the time, stated that the 2006 decline in investment buying was expected: “Speculators left the market in 2006, which caused investment sales to fall much faster than the primary market.” Housing prices nearly doubled between 2000 and 2006, a vastly different trend from the historical appreciation at roughly the rate of inflation. While homes had not traditionally been treated as investments subject to speculation, this behaviour changed during the housing boom. For example, one company estimated that as many as 85% of condominium properties purchased in Miami were for investment purposes. The Media widely reported condominiums being purchased while under construction, then being “flipped” (sold) for a profit without the seller ever having lived in them.  Some mortgage companies identified risks inherent in this activity as early as 2005, after identifying investors assuming highly leveraged positions in multiple properties. Nicole Gelinas of the Manhattan Institute described the consequences of failing to respond to the shifting treatment of a home from conservative inflation hedge to speculative investment. For example, individuals investing in equities have margin (borrowing) restrictions and receive warnings regarding the risk to principal; there are no such requirements for home buyers. While stock brokers are prohibited from telling an investor that a stock or bond investment cannot lose money, it was not illegal for mortgage brokers to do so. Equity investors are well-aware of the need to diversify their financial holdings, but for many homeowners the home represented both a leveraged and concentrated risk. Further, in the U.S. capital gains on stocks are taxed more aggressively than housing appreciation, which has large exemptions. These factors all contributed to heighten speculative behaviour. Economist Robert Shiller argues that speculative bubbles are fueled by “contagious optimism, seemingly impervious to facts, that often takes hold when prices are rising. Bubbles are primarily social phenomena; until we understand and address the psychology that fuels them, they’re going to keep forming.”  Keynesian economist Hyman Minsky described three types of speculative borrowing that contribute to rising debt and an eventual collapse of asset values :

•    The “hedge borrower,” who expects to make debt payments from cash flows from other investments;
•    The “speculative borrower,” who borrows believing that he can service the interest on his loan, but who must continually roll over the principal into new investments;

•    The “Ponzi borrower,” who relies on the appreciation of the value of his assets to refinance or pay off his debt, while being unable to repay the original loan.

    Speculative borrowing has been cited as a contributing factor to the subprime mortgage crisis

3. Credit Default Swaps (CDS):
Credit defaults swaps (CDS) are financial instruments used as a hedge and protection for debtholders, in particular MBS investors, from the risk of default. As the nett worth of banks and other financial institutions deteriorated because of losses related to subprime mortgages, the likelihood increased that those providing the insurance would have to pay their counterparties. This created uncertainty across the system, as investors wondered which companies would be required to pay to cover mortgage defaults. Like all swaps and other financial derivatives, CDS may either be used to hedge risks (specifically, to insure creditors against default) or to profit from speculation. The volume of CDS outstanding increased 100-fold from 1998 to 2008, with estimates of the debt covered by CDS contracts, as of November 2008, ranging from US$33 to $47 trillion. CDS are lightly regulated. As of 2008, there was no central clearing house to honour CDS in the event a party to a CDS proved unable to perform his obligations under the CDS contract. Required disclosure of CDS-related obligations has been criticized as inadequate. Insurance companies such as American International Group (AIG), MBIA, and Ambac faced ratings downgrades because widespread mortgage defaults increased their potential exposure to CDS losses. These firms had to obtain additional funds (capital) to offset this exposure. AIG’s having CDSs insuring $440 billion of MBS resulted in its seeking and obtaining a Federal government bailout. Like all swaps and other pure wagers what one party loses under a CDS, the other party gains; CDSs merely reallocate existing wealth. Hence the question is which side of the CDS will have to pay and will it be able to do so. When investment bank Lehman Brothers went bankrupt in September 2008, there was much uncertainty as to which financial firms would be required to honour the CDS contracts on its $600 billion of bonds outstanding. Merrill Lynch’s large losses in 2008 were attributed in part to the drop in value of its unhedged portfolio of collateralized debt obligations (CDOs) after AIG ceased offering CDS on Merrill’s CDOs. The loss of confidence of trading partners in Merrill Lynch’s solvency and its ability to refinance its short-term debt led to its acquisition by the Bank of America. Economist Joseph Stiglitz summarized how credit default swaps contributed to the systemic meltdown: “With this complicated intertwining of bets of great magnitude, no one could be sure of the financial position of anyone else-or even of one’s own position. Not surprisingly, the credit markets froze.”

4. Policies of Central Banks:
Central banks manage monetary policy and may target the rate of inflation. They have some authority over commercial banks and possibly other financial institutions. They are less concerned with avoiding asset price bubbles, such as the housing bubble and dot-com bubble. Central banks have generally chosen to react after such bubbles burst so as to minimize collateral damage to the economy, rather than trying to prevent or stop the bubble itself. This is because identifying an asset bubble and determining the proper monetary policy to deflate it are matters of debate among economists. Some market observers have been concerned that Federal Reserve actions could give rise to moral hazard.  A Government Accountability Office critic said that the Federal Reserve Bank of New York’s rescue of Long-Term Capital Management in 1998 would encourage large financial institutions to believe that the Federal Reserve would intervene on their behalf if risky loans went sour because they were “too big to fail.” A contributing factor to the rise in house prices was the Federal Reserve’s lowering of interest rates early in the decade. From 2000 to 2003, the Federal Reserve lowered the federal funds rate target from 6.5% to 1.0%.  This was done to soften the effects of the collapse of the dot-com bubble and of the September 2001 terrorist attacks, and to combat the perceived risk of deflation.  The Fed believed that interest rates could be lowered safely primarily because the rate of inflation was low; it disregarded other important factors. Richard W. Fisher, President and CEO of the Federal Reserve Bank of Dallas, said that the Fed’s interest rate policy during the early 2000s was misguided, because measured inflation in those years was below true inflation, which led to a monetary policy that contributed to the housing bubble.

5.  Inaccurate Credit Ratings:
Credit rating agencies are now under scrutiny for having given investment-grade ratings to CDOs and MBSs based on subprime mortgage loans.

These high ratings were believed justified because of risk reducing practices, including over-collateralization (pledging collateral in excess of debt issued), credit default insurance, and equity investors willing to bear the first losses. However, there are also indications that some involved in rating subprime-related securities knew at the time that the rating process was faulty. Emails exchanged between employees of rating agencies, dated before credit markets deteriorated and put in the public domain by USA Congressional investigators, suggest that some rating agency employees suspected that lax standards for rating structured credit products would result in major problems.  For example, one 2006 internal Email from Standard & Poor’s stated that “Rating agencies continue to create and [sic] even bigger monster—the CDO market. Let’s hope we are all wealthy and retired by the time this house of cards falters.” High ratings encouraged investors to buy securities backed by subprime mortgages, helping finance the housing boom. The reliance on agency ratings and the way ratings were used to justify investments led many investors to treat securitized products — some based on subprime mortgages — as equivalent to higher quality securities. This was exacerbated by the SEC’s removal of regulatory barriers and its reduction of disclosure requirements, all in the wake of the Enron scandal. Critics allege that the rating agencies suffered from conflicts of interest, as they were paid by investment banks and other firms that organize and sell structured securities to investors.  On 11 June 2008, the SEC proposed rules designed to mitigate perceived conflicts of interest between rating agencies and issuers of structured securities.  On 3 December 2008, the SEC approved measures to strengthen oversight of credit rating agencies, following a ten-month investigation that found “significant weaknesses in ratings practices,” including conflicts of interest . Between Q3 2007 and Q2 2008, rating agencies lowered the credit ratings on $1.9 trillion in mortgage backed securities. Financial institutions felt they had to lower the value of their MBS and acquire additional capital so as to maintain capital ratios. If this involved the sale of new shares of stock, the value of the existing shares was reduced. Thus ratings downgrades lowered the stock prices of many financial firms .In December 2008 economist Arnold Kling testified at congressional hearings on the collapse of Freddie Mac and Fannie Mae. Kling said that a high-risk loan could be “laundered” by Wall Street and return to the banking system as a highly rated security for sale to investors, obscuring its true risks and avoiding capital reserve requirements.

5. High Mortgage Risk Loan and Lending / Borrowing Practices:

Lenders began to offer more and more loans to higher-risk borrowers,  including illegal immigrants.  Subprime mortgages amounted to $35 billion (5% of total originations) in 1994,  9% in 1996, $160 billion (13%) in 1999,  and $600 billion (20%) in 2006. A study by the Federal Reserve found that the average difference between subprime and prime mortgage interest rates (the “subprime markup”) declined from 280 basis points in 2001, to 130 basis points in 2007. In other words, the risk premium required by lenders to offer a subprime loan declined. This occurred even though the credit ratings of subprime borrowers, and the characteristics of subprime loans, both declined during the 2001–2006 period, which should have had the opposite effect. The combination of declining risk premia and credit standards is common to classic boom and bust credit cycles.

In addition to considering higher-risk borrowers, lenders have offered increasingly risky loan options and borrowing incentives. In 2005, the median down payment for first-time home buyers was 2%, with 43% of those buyers making no down payment whatsoever. By comparison, China has down payment requirements that exceed 20%, with higher amounts for non-primary residences. Growth in mortgage loan fraud is based upon US Department of the Treasury Suspicious Activity Report Analysis.One high-risk option was the “No Income, No Job and no Assets” loans, sometimes referred to as Ninja loans.

Another example is the interest-only adjustable-rate mortgage (ARM), which allows the homeowner to pay just the interest (not principal) during an initial period. Still another is a “payment option” loan, in which the homeowner can pay a variable amount, but any interest not paid is added to the principal.

An estimated one-third of ARMs originated between 2004 and 2006 had “teaser” rates below 4%, which then increased significantly after some initial period, as much as doubling the monthly payment. Mortgage underwriting practices have also been criticized, including automated loan approvals that critics argued were not subjected to appropriate review and documentation. In 2007, 40% of all subprime loans resulted from automated underwriting. The Chairman of the Mortgage Bankers Association claimed that mortgage brokers, while profiting from the home loan boom, did not do enough to examine whether borrowers could repay and that is why Mortgage fraud by borrowers increased.

Impact of Crisis:

1.    Impact on Stock Markets Globally:- 

World stock markets have taken a beating, leading to a loss in confidence amongst investors who are stepping back in spite of several cuts in lending rates by the banks e.g. DJIA fell below 10,000 mark (first time in four years) plunging more than 800 points in a single day in October. The fall was mirrored in stock markets, such as NASDAQ, NYSE, Nikkei 225, London’s FTSE, Germany’s DAX etc.

2.  Losses to Investors:-
Both institutional investors and individual investors have suffered huge losses both in MBS and related products, and in equities. Banks alone are reported to have suffered USD 600 Bn of credit-related losses globally. According to IMF estimates, American and European banks are predicted to loose USD 10 trillion of assets.

3. Freeze in Inter Bank Credit:-
Failure of banks fueled anxiety in international banking markets leading to a freeze in inter-bank lending.

4. Increasing Unemployment:-
There have been job cuts in many companies across various sectors around the globe. This trend has not been limited to the financial sector alone. High number of layoffs were announced in the US through September 2008: 111,000 in financial sector, 95,000 in automotive sector, 62,000 in transportation, 51,000 in retail, 28,000 in telecommunications and more in other sectors.

5. Decline in Businesses Globally:-
There is considerable decline in business all over the world marked by reduced output and consumer spending, particularly in Britain, France, Germany and Japan. The industries being impacted include automotive, airline, building materials etc. Automotive companies such as GM, Ford and Toyota reported 45%, 30% and 23% decline in sales respectively, in October 2008.

6. Bailouts:- 
Several bailout packages have been announced by governments around the world to fight the growing financial crisis. The US has announced a USD 700 Bn bailout package for its banking sector, Germany announced a bailout of more than USD 200 Bn and Britain more than USD 500 Bn for this financial crisis.

Stability of Islamic Banks in times of Financial Crises:

Financial stability refers to an absence of excessive fluctuations in the financial institutions and markets. A market with fairly constant output growth is stable. An economy with frequent large recessions, pronounced business cycles, variable inflation or frequent financial crises would be considered economically unstable.
Islamic banks and markets are more stable than conventional banks and markets. This seems to be extraordinary; while one bank is stable the other is unstable and especially so in a time when global markets are in crisis. This is no doubt attributable to the different systems of risk sharing (Islamic) and risk transferring (conventional). That is why Islamic banks today are not in crisis in the context of the financial crisis triggered by a dramatic rise in mortgage delinquencies and foreclosures in the United States. No doubt, Riba (interest /usury) and Maysir (gambling, speculative activities similar to gambling) are the major factors leading to the current financial crisis. Islam’s prohibition of Riba and Maysir along with other Islamic values and morals, and recognizing others’ interest in one’s economic fortunes, if adhered to, could not have led the world to the present day financial crisis. Keeping individuals and Societies free from financial and economic crises can clearly be seen as one of the objectives of such institutions [1].

The Islamic system does not allow the creation of debt through direct lending and borrowing. It rather requires the creation of debt through the sale or lease of real assets by means of its sales- and lease-based modes of financing such as murabaha, ijara, salam, istisna and sukuk. The asset which is being sold or leased must be real, and not imaginary or notional; the seller must own and possess the goods being sold or leased; the transaction must be genuine with the full intention of giving and taking delivery; and the debt cannot be sold and thus the risk associated with it cannot be transferred to someone else. [2]

Institutions offering Islamic financial services constitute a significant and growing share of the financial system in a number of countries. Since the inception of Islamic banking about three decades ago, the number and reach of Islamic financial institutions worldwide has risen from one institution in one country in 1975 to over 300 institutions operating in more than 75 countries [3]. In Sudan and Iran, the entire banking system is currently based on Islamic finance principles. Islamic banks are concentrated in the Middle East and Southeast Asia, but they are also present as niche players in Europe and the United States. Total assets of Islamic banks worldwide are estimated at about $250 billion, and are expected to grow by about 15 percent a year [4] [5]

Authors such as Sundararajan and Errico (2002); Iqbal and Llewellyn (2002); and World Bank and International Monetary Fund (2005) note that the following features need to be taken into account when assessing stability in a financial system with a significant presence of Islamic banks:

PLS financing shifts the direct credit risk from banks to their investment depositors, but it also increases the overall degree of risk on the asset side of banks’ balance sheets, as it makes Islamic banks vulnerable to risks normally borne by equity investors rather than holders of debt.

•     Operational risk is crucial in Islamic finance. Operational risk is defined as the risk of losses resulting from inadequate or failed internal processes, people and systems or from external events, which includes but is not limited to, legal risk and Shari’ah compliance risk. According to the theoretical literature reviewed here, the importance of operational risk in Islamic finance reflects the complexities associated with the administration of PLS modes, including the fact that Islamic banks often have limited legal means to control the agent-entrepreneur.

•     PLS cannot be made dependent on collateral or guarantees to reduce credit risk.

• Product standardization is more difficult due to the multiplicity of potential financing methods, increasing operational risk and legal uncertainty in interpreting contracts.

• Islamic banks can use fewer risk-hedging instruments and techniques than conventional banks and traditionally have operated in environments with underdeveloped or nonexistent interbank and money markets and government securities, and with limited availability of and access to lender-of-last-resort facilities operated by central banks. However, the significance of these differences has decreased due to recent developments in Islamic money market instruments and Islamic lender-of-last-resort modes and the implicit commitment to provide liquidity support to all banks during exceptional circumstances in most countries.

•     Non-PLS modes of financing are less risky and more closely resemble conventional financing facilities, but they also carry risks (such as elevated operational risk in some cases) that need to be recognized.
   
    As anyone who has tried to define financial stability knows, there is as yet no widely accepted model or analytical framework for assessing financial system stability and for examining policies as there is for economic systems and in other disciplines. in simple words, financial stability can be defined as a situation where the financial system is able to function prudently, efficiently and uninterrupted, even in the face of adverse shocks. Some financial experts define ‘Financial instability’ as ‘Conditions in financial markets that harm, or threaten to harm, an economy’s performance through their impact on the working of the financial system. Such instability harms the working of the economy in various ways. It can impair the financial condition of non-financial units such as households, enterprises, and  governments to the degree that the flow of finance to them becomes restricted. It can also disrupt the operations of particular financial institutions and markets so that they are less able to continue financing the rest of the economy. It differs from time to time and from place to place according to its initiating impulse, the parts of the financial system affected, and its consequences. Threats to financial stability have come from such diverse sources as the default on the bonds of a distant government; the insolvency of a small, specialized, foreign exchange bank; computer breakdown at a major bank; and the lending activities of a little known bank in the U.S. Midwest[6]. Another author has defined it as follows: “It seems useful…to define financial stability…by defining its opposite:  financial instability. In my view, the most useful concept of financial instability for central banks and other authorities involves some notion of market failure or externalities that can potentially impinge on real economic activity [7]. “Financial stability means that the financial system is robust to disturbances in the economy, so that it is able to mediate financing, carry out payments, and redistribute risk in a satisfactory manner.”[8]

Conclusion:
The basic concept of Islamic banking goes back to 1430 years.  But the world’s first modern Islamic bank did not open until 1963(first Islamic bank established in Egypt in 1963) and later in 1975 IDB and Dubai Islamic bank were opened. Now there are more than 300 Islamic banks and financial institutions world wide with a value estimated at $ 1 trillion, which is expected to reach $ 2 trillion by 2013. The Islamic finance system introduces greater discipline into the economy and links credit expansion to the growth of the real economy. It is capable of minimizing the severity and frequency of financial crises. Islamic finance has capacity to reduce the problem of subprime borrowers by providing them loans at affordable terms. This might definitely have saved billions of dollars that have been spent to bail out the rich bankers. 
 
Renowned Muslim economist Prof. Nejatullah Siddiqui while reflecting on the present crisis says that conventional bank interest is gambling like speculation which is based on risk shifting as distinct from risk sharing. Debt financing coupled with speculative products whose intricacies defy understanding provide ample opportunities to greedy profit maximizing agents to exploit the aspirations of ordinary investors and for goading home owners and consumers into living beyond their means and chasing untenable dreams. Though these greedy people swear by the name of efficiency and innovation, the champions of deregulation and laissez faire have their self interest in view, not the social welfare. Even during the crisis, the Islamic bank of Britain in London, England has issued $25 million loan to Blue Ocean European Company.

Many Western Banks and investment firms in USA, including Chase Manhattan, Goldman Sachs, Wellington Global Administrator, and ABC investment Services Co. have added Islamic finance divisions. The amount of wealth under Islamic finance sector, the halal banking system, is said to be over $500 billion–that is, roughly the size of Wells Fargo Bank, America’s fourth largest bank. And Hussain A. Hassan, of Deutsche Bank, predicts that Islamic finance will be the world’s fastest growing banking sector for years, based on what he calls a modest estimate of 20% annual increase in deposits.

Frank Gaffney wrote an Op Ed in The Washington Times dated September 16, 2008, under the heading “ Wall Street, What Next?” He says : “Tragically, in the process of leaping out of the scalding subprime frying pan, Wall Street is heading directly into a fire that promises, if anything, to be more devastating than the present disaster. Incredibly, it bears all the hallmarks of subprime with respect to a lack of transparency, a systematic failure to disclose and an utter absence of due diligence, good governance and accountability. The next “what” is called Sharia-Compliant Finance (CSF)”

Islam has the solution to the problems of the west, in the same way as Islam has the solution to the current financial crisis. Due to the inherent nature of Islamic banking especially as it does not deal in debt trading and distances itself from market speculation that takes place in European and American banks, Islamic banks remain unaffected by the current financial crisis.

References:

[1]     World Financial Crisis: Lesson from Islamic Economics by Dr. M. Fahim Khan Islamic Society for Institutional Economics www.i-sie.org.

[2]    Islamic finance panacea for global crisis. by Dr Umar Chapra, www.arabnews.com

[3]     El Qorchi, Mohammed, 2005, “Islamic Finance Gears Up,” Finance and Development (Washington: International Monetary Fund).

[4] Choong, Beng Soon, and Ming-Hua Liu, 2006, “Islamic Banking: Interest-Free or Interest-Based?” Available at SSRN: http://ssrn.com/abstract=868567.

[5] Ainley, Michael, Ali Mashayekhi, Robert Hicks, Arshadur Rahman, and Ali    Ravalia, 2007, Islamic Finance in the UK: Regulation and Challenges (London: Financial Services Authority).

[6]     Chant, John, 2003, “Financial Stability As a Policy Goal,” in Essays on Financial Stability, by John Chant, Alexandra Lai, Mark Illing, and Fred Daniel, Bank of Canada Technical Report No. 95 (Ottawa: Bank of Canada), September, pp. 3–4.

[7]    Ferguson, Roger, 2002, “Should Financial Stability Be An Explicit Central Bank Objective?” (Washington: Federal Reserve Board).

[8]    Norwegian Central Bank, 2003, Financial Stability Review, February