Islamic Finance. An opportunity at a time of Crisis, By Nafis Alam, – School of Business – Monash University Sunway campus, Malaysia

© Islamic Finance Today

Nafis Alam is currently attached to the School of Business at Monash University Sunway campus, where he works as Lecturer (Islamic Finance) and has also embarked on a PhD program in Islamic Finance. Nafis has co-authored the ?Encyclopedia of Islamic Finance? which is a first of its kind.

Islamic banks operating under the guided principles of Islamic economics have succeeded where all others have failed, withstanding the US subprime mortgage crisis which left global markets shattered. Islamic banks had shunned collateralized debt obligations linked to subprime, or high risk, mortgages because such complex instruments do not comply with the Shari?ah. Global conventional banks from Citigroup to UBS have written down more than US$80 billion in credit market losses since October 2008 as defaults on subprime mortgages triggered a credit crisis that is tipping the global economy into recession. By contrast lenders in the Gulf and Malaysia, the global hubs of Islamic finance, have reported minimal or no subprime related losses. The subprime crisis could provide the Islamic banking industry with greater opportunity for growth, both from conventional retail customers looking for an alternative, and also from the collapse of conventional asset prices.

Current Financial Crisis and Islamic Economics

The current crisis emanating from US financial markets and spreading to other developed and fast developing countries like Japan,

European countries and Singapore, is threatening a global meltdown leaving the entire world poorer and with grim forebodings of the future. It started as a credit crunch due to highly over-stretched leverage, was aggravated by the complexity of the products and reached its peak due to moral failure generating conflicts of interest and mismatch between incentives of the various groups and individuals involved in the scheme.

It can be argued that debt-finance coupled with speculative products whose particulars 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 unsustainable dreams. A world of banking and finance without Riba and Maysir can be suggested as the best alternative to the current scenario. In this new environment risk sharing will replace risk shifting and morality, advising people to be moderate in their material pursuits and considerate about public good in their private decisions, coupled with realism, will serve as the corrective to self-destructive outgrowths of current financial capitalism. It can be also noted that for this alternative model to be robust and resilient, morality has to be rooted in spirituality. This will provide a basis for willing acceptance of social norms, state supervision, regulation and intervention in the market based on values rather than interests.

Currently, financial institutions include banks, investment companies, insurance companies etc. managed by hired professionals. Those who govern financial conglomerates by virtue of owning enough shares have motives different from ordinary shareholders. Almost the entire population in developed countries is involved in supplying capital through purchase of stocks, bonds, insurance policies, pension funds, etc. While these ?principals are interested in profits they care about many other things too, among them stability, jobs, social justice, and anxiety free communities. Not so the hired managers who consider profit maximization to be their mission as it earns them maximum bonus and continued employment. There are those amongst middlemen who earn fees. They earn more when transactions multiply. In an environment where no one cares about others, focused as everyone is on his or her own interest, public interest is supposedly guarded by regulators.

If we go deep into the roots of the crisis, we can consider Maysir infested financial products like Credit Default Swaps (CDS), the inverted pyramid of debts and the shortage of liquidity, all the features of the current situation, are rooted in the moral failure as described above. It could have been different. The underlying reason can be found in the separation of economic life from morality after the secularization of society in the wake of the so-called age of enlightenment. Islamic civilization has the instruments to pre-commit man in society to certain values leading to rules i.e. abolition of interest and gambling.

Why does Islamic finance prohibits Maysir or gambling? Firstly, gambling does not create additional wealth. Games of chance only transfer wealth from its (losing) owners to new (winning) ones. Considering the human resources consumed in the process, wealth transfers through games of chance cannot be considered to be efficient. They do not serve any social purpose. Other absolving circumstances like the revenue to state in form of taxes or employment generated by casinos, lotteries, etc. cannot be considered as advantageous until the acceptability of gambling itself is established.

Risk shifting can also be considered as a form of gambling. One who buys risk exchanges a definite amount of money (the price) for an uncertain amount of money, whose delivery itself is not certain. CDS are an appropriate example. The millions of loans made by a bank are each subject to the risk of default (credit risk) in various degrees. The risks attached to each loan are unique. The institution undertaking to pay for all defaulters among, say a million borrowers has no scientific basis for measuring the risk it is taking. There is no long history to fall back on. The law of large numbers does not apply. It is just taking chances, gambling. The banks that so protect themselves against credit risks are emboldened to give more and more loans. That is how aggressive lending policy gained an impetus. The sub-prime mortgage crisis would not have occurred without the speculative deals like CDS. Aggressive lenders offered to refinance mortgages on the basis of rising home prices, virtually converting owned homes into ATM machines, sending people on a buying spree, some of it on instalment purchase basis, encouraging an expansion that had little basis in the fundamentals: earning powers, disposable incomes and savings and investments.

The Islamic approach to risk is realistic but cautious. It does not allow deals involving excessive uncertainty (Gharar). It encourages sharing arrangements for facing risks. The additional wealth created with the use of existing wealth through risky ventures should be shared between fund users and fund owners while both bear the risks involved and the resulting losses. Differences in the participants? perception of risks involved will be decisive in determining the terms of bargain between those sharing risks. Even though the motive of each party is making profits, it is very different from taking chances in gambling. There is real wealth to be created, real gain to be reaped. It is different in case of risk shifting as in CDS. Neither the buyer nor the seller of risk has any stakes in real wealth creation. As in gambling only one party actually gains, either the seller of risk or the buyer. It is different in risk sharing in which both parties gain (or lose). Like gambling, risk shifting is a zero sum game.

Risk sharing fits in with a system that integrates risk management with value creation. The Islamic institutions of Musharakah, and Mudarabah, for example target value creation and are good ways of managing risk. In a healthy venture fear of loss works to counter-balance hope for gain. When a system allows shifting the risk at a cost the fear factor becomes inoperative in so far as the seller of risk is concerned. It is worse when the government takes over the risk similar to what happened in case of Fannie Mae and Freddie Mac in USA. Such a system is heavily leaned towards the rich and leads to greater inequality as it protects the lenders but leaves the borrowers to fend for themselves. This is the feature of the current system that led to an almost universal blubber in that it amounted to privatizing gain and socializing pain.

In this context we can refer to an Islamic approach as encapsulated in verse 278-281 of the second chapter of the Quran:

?Believers! Have fear of Allah and give up all outstanding interest if you do truly believe. But if you fail to do so, then be warned of war from Allah and His Messenger. If you repent even now, you have the right of return of your capital; neither will you do wrong nor will you be wronged. But if the debtor is in straitened circumstances, let him have respite until the time of ease; and whatever you remit by way of charity is better for you, if only you know.? [2:278-81]

In effect the above is advising how to handle a crisis caused by default. A crisis like the sub-prime crisis in US (if it ever occurred in an Islamic interest free system based on risk sharing) would be handled not by extending credit to lenders but by giving more time to borrowers and writing off some of the debts.

Islamic finance could have prevented subprime crisis

The global economic crisis sparked by the US subprime mortgage meltdown would not have occurred if Islamic principles were applied in international financial markets, as noted and confirmed by many Islamic scholars. Defaults in the US market from risky mortgages have caused major global credit turmoil, as massive US losses led to a squeeze on international credit markets, and subsequent fall in global equity markets.

The mortgage crisis would have been unthinkable under Islamic principles because crises such as this would technically be unthinkable in the Islamic capital markets sector as it would be against Shariah principles to sell a debt against a debt. The subprime mortgage crisis had seen trillions of dollars traded without the backing of assets. If such transactions followed the Islamic finance model it would have easily prevented the current economic crisis.

The subprime mortgage debt write downs have had a crippling effect on economies the world over. They have raised the cost of debt and, therefore, access to finance and, more importantly, increased the cost of living. Subprime mortgage debt write downs and their subsequent large scale affects the world over, were for the most part, attributed to two factors: the first being the relaxing of mortgage credit criteria in developed economies on the assumption that real estate prices were on the rise and therefore there was sufficient collateral to risk providing loans to individuals without a substantial credit standing. The second reason was the role of the financial markets in the securitisation and subsequent repackaging of such mortgage-based obligations into all types of securities with numerous tranches (or seniority status), without a substantial or exact trace to the underlying assets of the securities. These, in turn, awakened a sleeping tsunami in the financial industry, including the substantial malpractices of highly geared Investment banks, which potentially suffered from questionable risk management practices. More importantly, it raised questions on the integrity of the sophisticated financial system the modern world has developed over the past decade, a system in which the regulators are trying desperately to catch up with market innovation, particularly in the space of derivatives and debt markets. Another school of thought is emerging which characterises this largely to the role of speculators in the derivative markets. They stressed that the lacklustre performance of the real estate and equities markets in the developed world has resulted in traders shifting their attention to commodities, which are proving to generate substantial returns. A large part of this commodities trading is done on futures markets, which some conjecture may have a substantial effect on today?s prices, since current demand may be driven by future expectations of prices.

Two of the features of the current crisis would not have existed in pure Islamic economies based on sound Islamic financial principles. For one, the trading of debt, as in the case of the mortgage backed securities is seen as usurious in the domain of Islamic commercial jurisprudence. Hence, the re-packaging of debt obligations into several layers without a substantial trace to the underlying asset is largely frowned upon by Shariah scholars. Islamic bonds, carrying unique structure features, cannot fall victim of a crisis such as subprime mortgage crisis. Subprime mortgages are backed by dubiously rated collateralized debt packages which subsequently precipitated a global credit crunch. Islamic finance principles stipulate that deals must be based on tangible assets and require tight controls on debt levels, features analysts say offer some protection to investors and ensure corporate accountability. Islamic securities should be asset-based. A direct link to the asset is the substantial basis of the asset generating returns, although this may not be true for all Islamic securities, which have largely succumbed to the influences of conventional securities.

Second, futures-markets trading are largely disallowed. Goods that do not exist, goods that the seller does not own or cannot deliver cannot be the subject matter of an Islamic contract, which means all types of futures contracts are disallowed in Islamic economies. The only exceptions to this rule are the contract to construct (only applies to specific customisable goods made to order, not commodities) and the contract better known as Salam, which allows for future delivery of non-existent fungible commodities, albeit with extensive prohibitions including the full payment of the price in advance.

That full payment has to be made upfront in Salam is itself a great disincentive to engage in speculative trading unless there is a genuine need for the underlying commodity by the buyer. Even if there is no genuine need by the buyer of the commodities and the buyer would like to speculate by holding the assets, Islamic commercial law disallows the trading of such future obligations until the asset is actually delivered. This is markedly prohibitive compared with the conventional futures trading in the West, which allows for futures trading without payment and without settlement until the contractual date.

A commitment to Islamic finance can come from those individuals who believe not only in its visible ethical and social justice rules but also in the greater wisdom of the divine source, regardless of whether the benefits of such rules are apparent or measurable. While we wait for the empirical evidence to turn up on the causes of these economic crises, perhaps we should ponder on whether these rules laying down certain limits on Islamic finance do have some divine sources behind them; wisdom that is able to foresee the macro-economic effects of our micro-economic decisions such as the trading of a simple obligation.

Thus it can be seen that the Islamic finance system, which introduces greater discipline into the economy and links credit expansion to the growth of the real economy, is capable of minimizing the severity and frequency of financial crises such as the subprime crisis.

Financing extended through Islamic products can expand only in step with the rise of the real economy and thereby help curb excessive credit expansion. The significance of the condition that prevents a creditor from transferring the risk to someone else by selling the debt will help eliminate a great deal of speculative and derivative transactions where there is no intention of giving or taking delivery. It will also help prevent an unnecessary explosion in the volume and value of transactions and the debt from rising far above the size of the real economy.

It will also release a greater volume of financial resources for the real economic sectors and, thereby, help expand employment and self-employment opportunities and the production of need-fulfilling goods and services.

The discipline that Islam wishes to introduce in the financial system may not materialize unless the governments concerned reduce their borrowing from the central bank to a level that is in harmony with the goal of price and financial stability. In an Islamic system, credit is primarily for the purchase of real goods and services which the seller owns and possesses and the buyer wishes to take delivery.