© Islamic Finance Today
Described by The Economist as a “polymath”, and by his clients as “brilliant and fresh”, Joe DiVanna is the Managing Director of Maris Strategies Limited, an innovation think-tank providing research and advisory services to the financial services industry, global businesses and governments. He is the author of the annual Top 500 Islamic Banks supplement published in the November issue of The Banker Magazine. His latest book ‘New Financial Dawn: The Rise of Islamic Finance’ co-authored with Antoine Sreih was published by Leonardo and Francis in August 2009
The global capital markets and their associated banking institutions are experiencing a collapse in value due to an overwhelming loss of confidence by consumers, investors and businesses. The credit crisis has eroded market confidence and curtailed the appetite for risk to only the most fearless of investors in global markets. In the conventional system, the recent crisis has left bank stocks, which have traditionally been stable, slow-growing, losing between 50 and 90 percent of their value in a very short amount of time. Market dynamics have taken a new meaning, as previous indicators of a bank’s performance have been jettisoned in favour of irrational reactions to disassociated information on potential threats to corporate performance. Markets have moved from investor- to speculator-based as short-termism with a continued focus on a one-quarter ahead mentality rule the day.
Counter to this trend has been the steadfast rise of Islamic finance, which has maintained a 27.8 percent rise in Shariah-compliant bank assets from USD $500.4 billion in 2007 to USD $639 billion in 2008 according to The Banker.
Social Financial Cohesion
Financial institutions provide a nation with something not found in other industries, namely social financial cohesion. Financial services are the “glue” that holds a nation’s economy together by facilitating the commercial needs of business and making possible the wide variety of lifestyles enjoyed within a nation. Although this is an oversimplification of what is indeed a very complex relationship between financial service providers, government and consumers, it does provide an insight to why during 2008, the US government elected to bail out banks and rejected appeals from US automakers for similar measures.
In the context of Islamic finance, facilitating social financial cohesion is one of the main tenets of why Shari’ah-compliant banks operate. It is because banks provide social financial cohesion that governments act to preserve banks during times of insolvency, and regulators move to keep markets functioning. One could argue that during the course of 2008, actions taken by central banks to boost liquidity and support markets had less to do with supporting individual financial institutions and more to do with boosting the level of confidence in world markets. Although one rarely thinks about trust as an element of the value proposition of a financial institution, it is clear that without trust a bank cannot facilitate the economic activities of businesses and consumers. Trust cannot be purchased, manufactured or fabricated; trust must be earned. Naturally, trust between a bank and a customer is bidirectional: banker must demonstrate trust and customers must also be trustworthy.
When customers distrust banks, there is a flight towards a cash economy. This is frequently the case in emerging markets. In mature markets, when a bank loses customer trust there is an exodus to other banks. When banks distrust customers, credit is tightened, as banks alter the criteria for lending to systematically eliminate customers who are potential defaulters. Finally, if customers are indeed not trustworthy, they default on their obligations, which is, one could argue, one of the root causes of the sub-prime lending crisis.
Fundamentally, the credit crisis in the United States has three market actors: creditors (banks and other lenders), regulators (market referee and rules maker) and borrowers (consumers and businesses). The vast majority of the press coverage surrounding the crisis has focused on the role of the first group of actors, namely the banks as creditors and their successive laxity in credit policies over the past twenty years. Few stories discussed how the actions of banks were predicated on a continual need to meet shareholder expectations of growth and profit. For the sake of brevity, let us agree that the role the banks played established a catalyst for the crisis.
The second group of market actors portrayed by the media are regulators who oversee market activities by establishing the boundaries of banking behaviour within a nation state. Their role in the crisis has yet to be fully understood. As regulators, they create the rules which govern banks’ actions, and define what activities might violate the public trust. Consumers form the third group of actors; media coverage on the role of consumers as the originators or triggers to the crisis is rather more scarce, although consumers were, by all accounts, the reactants in the catalyst that perpetrated the crisis when they demonstrated their inability to repay loans. In the media search for the guilty party to be blamed for the crisis, perhaps we are overlooking the true culprits, namely the consumers and their behaviours of living beyond their means and greed. An oversimplification of the credit crises is that bankers misplaced their trust in subprime customers and customers misplaced their trust in bankers to provide them with financial acumen. One could argue that banks and customers naively misplaced their trust in governments’ ability to monitor and regulate the situation. As a result, in early 2009 market confidence and public trust in most banking systems across developed economies had severely decreased.
Once signs of a breach of trust occurred, bankers—remembering that shareholders are often ill tempered and will sell shares on the smallest item of bad news—moved unilaterally to tighten credit by establishing increasingly stringent criteria for lending. One thing that sets the current economic crisis apart from historical market crashes is the unprecedented amount of cross-border financial product interoperation. In the summer of 2007, the United States credit crisis hit Europe as French insurer AXA and German bank IKB saw devaluations in funds that were exposed to risks in the US markets. August of 2007 saw BNP Paribas freeze the Parvest Dynamic Fund, Euribor Fund and Eonia Fund as the market for mortgage-backed securities imploded. As the crisis continued, the market witnessed the collapse of Bear Stearns, the government takeover of Fannie Mae and Freddie Mac, and the disintegration of Lehman Brothers. In 2008, the markets saw the semi-nationalization of banks across the world, including venerable banks such as CitiGroup, Lloyds, Royal Bank of Scotland, Halifax and many others. The shear enormity of the crisis may never be fully understood as market watchers fear the US $800 billion banking bailout is the beginning of a more serious problem. Let us be clear on the role of perceived trust; in the case of Bear Stearns, for example, their collapse was not a product of insolvency. Rather, other market players simply feared that as market pressure increased they could no longer place their trust in the company. One could argue that the same lack of confidence was the undoing of Lehman Brothers as well.
Consumers and businesses in any given society inherently trust banks as the neutral third party to facilitate transactions between two parties. In the past, the word trust was sometimes incorporated into the name of the financial institution such as Manufacturers Hanover Trust (United States) or the Overseas Trust Bank (Hong Kong). Even today, banks still use the word trust in their names and brand identities such as First Trust Bank (United Kingdom), Cayman National Bank & Trust Company (Cayman Islands), and The Trust Bank (Ghana). Although banks rarely market themselves with slogans like “trust us” or “you can place your deposits and trust in us”, their brand identities reflect a perception of an implied trust. Historically, trust in a bank’s brand identity was straightforwardly represented by heavy stainless steel bank vault doors that were often within view of customers, tall marble columns outside the front door representing strength, and bars on the windows to imply impregnability. The image of a bank was to portray a sense of trust that customer’s deposits were secure. For an illustration of how trust has played such a large role in perpetuating confidence in a nation’s financial system, we can cite a historically recent example. To reinforce the ideal of trust in the US market after the collapse of the financial markets in 1929, the Federal Deposit Insurance Corporation (FDIC) was created from the Glass-Steagall Act of 1933 to guarantee the safety of deposits.
In the later part of the twentieth century, the imagery of vaults and columns was replaced by skyscrapers and other symbols of power to provide customers with a sense of confidence that a big bank was safe, and unable to fail.
Trust in Muslim Communities
Just as trust plays an integral role in providing social financial cohesion in non-Muslim societies, Shariah-based finance fills the same role in Islamic communities. Shariah-based finance provides the economic glue that enables society to function by facilitating commerce in much the same fashion as its conventional counterparts. What is different between Islamic finance and conventional finance is an explicit versus an implicit trust. In conventional banking markets, there is an implied trust between an institution and the customer, represented by images of power, size of institution and number of customers. In Islamic finance, trust is explicit, declared by both the institution and the customer as the role played by the institution is that of an impartial facilitator of financial transactions. Therefore, trust in a Shariah-compliant institution is paramount for it to achieve its objectives, facilitate the lifestyles of customers and to serve the greater needs of society.
As trust in conventional markets continues to erode, Islamic finance as an industry is rapidly evolving into a viable alternative to conventional sources and forms of capital for Muslim and non-Muslim business. To describe Islamic finance as simply a system of finance that happens to be devoid of interest understates the true nature of the Islamic ideal, namely the fair and equitable exchange between two parties. Islamic finance is the execution of a financial transaction through a trusted third party that acts to balance risk and return between parties. Corporations such as Tesco (UK) and Toyoto (Japan) have used Islamic financial instruments to meet their capital requirements.
Being so placed outside the global crisis which has increased lack of faith in the conventional banking system, Islamic finance experiences a new dawn. The sheer rise in Islamic finance activity across the global is testimony to the fact that far from being a fad or a system which is ethnically or religiously disparate from the global community, Islamic banking and finance is here to stay.