Credit crunch: islamic perspective

Chapter IV: lessons from the financial crisis

Islamic finance was initiated as a Shariah based choice. For the practitioners of the Islamic religion, it is now presented as the ultimate alternative after the financial crisis. Islamic finance has been insulated from the financial crisis in certain aspects.

According to the Vatican «ethical spirits on which Islamic finance is based may bring banks closer to their clients and to true spirit which should mark every financial service»^94(*).

Islamic finance principles address key issues of the crisis. However, despite its advantages, Islamic finance as currently practiced cannot rise as an alternative to conventional finance. However, lessons can be learnt from it that can be applied to conventional banking methods.

1) Advantages and disadvantages of Islamic finance

A) Advantages of Islamic finance

According to Hans Visser^95(*): «Islamic finance presents potential positive effects: lower danger of insolvency, financial crisis, speculation, participation in the financial system».

a) Risk profile of Islamic finance institutions

The common view considers Islamic finance to be less risky or safer than its opponents. This was always considered to be a disadvantage because the lesser the risks, a business takes the less benefits it generates. However, under the current turmoil, safer investments turn to be an advantage.

The misconception of Islamic finance's risk profile shows that the Islamic institutions are not risk free but it is it is the management of these risks that makes Islamic institutions secure.

Whereas, the conventional banks take guaranteed returns on their investments, Islamic banks practices rely heavily on investment in business which includes the risk of losses and benefits^96(*).

Islamic finance faces «asset risks, market risks, Shariah non-compliance risk, greater risk of returns risk, greater fiduciary risks and greater legal risks^97(*)».

Hans Visser states the importance of operational risk in a system based on technology^98(*).

The credit risk in Islamic finance is minimal. The deposit taking is based on PLS (profit and loss sharing) methods. This means that the bank and the depositors share losses. However the margin of losses is very small. The loans are gathered in a pool and invested in different projects. Overall, the possibility of losing in sum is lower due to the diversification so the risk for the depositors to lose money is lower.

b) Providing Shariah compliant instruments

Another advantage of Islamic finance is providing Shariah compliant finance to those pious people in quest for investments which respect Islamic ethos.

Numbers of scholars disagree with the Islamic practices which diverge from the theory. The real Islamic techniques are based on PLS methods like Musharakah and Mudaraba .However, Murabaha who according to Taqi Usmani^99(*) was allowed exceptionally became the rule.

Some have gone further in their critic suggesting that it is a plot created by the gulf countries to attract petro dollars money to Islamic countries; they use «hiyal» (stratagems, deviated tactics) to extract indirect interest^100(*).

Also Mudaraba and Ijarah are considered Shariah compliant. They are the rule because they suit the need of the community which must act in a competitive field and must follow innovation to get adapted, without it there is not only growth but slow death^101(*). The allowance of the Shariah boards gives credibility to the instruments used.

However some work must be done on the authenticity of the Islamic finance operation which will be discussed later on.

No study has been conducted on the number of Muslims who don't invest their money because of the lack of existence of suitable investments. However, it is logical to suggest that the existence of Islamic finance attracts more funds into the system which can activate the economic cycle.

c) Anti crisis model

The most relevant advantage in the recent crisis is the fact that Islamic finance proved to be an anti crisis model.

However, many critics state that the Islamic finance institutions weren't affected because they were simply invested in other products than the ones concerned by the crisis. A question must be asked that if a subsequent turmoil were to hit the oil price, will the Islamic banks be financially viable and continue to be resilient?

The secret of Islamic finance protection against crisis is the moral hazard incentive.

According to Chapra^102(*), the absence of depositors' protection in Islamic finance is a safety net from crises.

Being aware of the absence of protection, the investors will tend to invest in credit worthy institutions.

The depositors are not protected, with the absence of a depositor protection scheme as a safety net, they are more concerned with the soundness of the institution they are trusting with their funds.

Aware of the check exercised, the institutions try to preserve their self image. They tend to rely more on safe investments or backups because there understand that there aren't any institutions that are too big to fail.

The institution regarding this fact will exercise more severe credit worthiness checks of the borrowers or the projects they are investing in. This will serve as a safety net against possibilities of insolvency.

However, a question about the effects of the investor supervision is questionable .The availability of information and the professionalism of investors to analyse this information is problematic.

In the same way, conventional banks are careful about their business according to KYC (Know Your Customer) they check the person background and credit worthiness before granting a loan. However, the last crisis was due to subprime loans which are loans that couldn't be paid because the bank didn't exercise their function of control which was a major factor to the crisis.

Another valid point in the Islamic banking model is the relationship between the banks and their shareholders. In fact Islamic banks are usually small; their relations with their shareholders are more personal not only commercial so in case of problems the shareholders stand up by the institution which avoids bank runs.

These mutual control and close relationship net avert insolvency of Islamic institutions.

d) Islamic finance emphasises on productivity and risk sharing

In Islam, money cannot generate money. In order generate a benefit; one must participate in the production or the risk taking procedure. This is usually achieved by the Islamic contracts or profit loss sharing principle.

Islamic finance includes less speculation. In fact, the transactions relying on gharar khatir (excessive uncertainty) and Maysir (gambling) are prohibited.

Short selling defined as a selling of a product at a price in the hope of buying it in the future when the prices will drop down is prohibited under Islamic finance. It includes forbidding short selling which relies in selling what is not in the seller's ownership.

Riba operations are also prohibited. This makes illegal all the operations based on derivatives and options because it includes interest selling. 'The Islamic banking industry escaped the immediate fallout from the industry, largely because the ban on interest prevented banks from investing in the assets that turned toxic for conventional banks'^103(*)

Islamic finance is based on participation and risk sharing. Unlike conventional banks, Islamic banks don't provide loans; they provide funds according to profit and loss sharing methods. According to Siddiqi^104(*), Islamic finance's approach to risk is realistic but cautious.

The loss and sharing modes put emphasis on the viability of the project and also on the risk profile of the customer. This emphasis on productivity is another advantageous feature of Islamic finance.

B) Disadvantages of Islamic finance

However, Islamic finance presents some disadvantages.

According to Hasser^105(*), Islamic finance comparing to conventional banks presents some disadvantages:

`More risks for depositors, higher costs, and principal-agent problems, inadequate financing, limited supply, insurance with pitfalls, less scope for diversification and hedging'. In addition to some of these points we will talk about tax and regulation issues.

a) Risk for depositors

The reduction of danger of insolvency is counter balanced by increased risks for depositors.

The profit and loss sharing model means depositors' interest can fluctuate. Even if the depositors can monitor the bank, their scope of managing is very restrained to the voting measures against the management or retrieving the funds.

However, it is recommended that under PLS sharing modes and as a safety net, banks can reduce their percentage of participation in the contract bearing losses, so depositors won't be affected.

It is very usual in a small traditional bank that depositors are the shareholders .Their margin of action is widespread and this can limit the disadvantage of Islamic finance.

Ummer Chapra^106(*) recommends that depositors must be represented in the council and administration of banks to participate in the decision making process.

b) Higher costs

Islamic finance is too complicated and expensive.

While the conventional system is more competitive, each Islamic transaction requires more than one contract, which is highly costly.

Banks have to deal with delivery issues which are not part of their business.

The required guarantees can limit the room of manoeuvre of the clients.

c) Diversification of hedging and growth

Futures, forwards, derivatives are banned. By consequent, the possibility of hedging against risks is very limited.

The possibility of investing in higher risk projects and triggering higher risk return is very limited.

The rule of `no risk, no gain' and the perspective of growth and innovation are restrained.

d) The principal-agent problem

The principal instruments are vested compliant to Shariah law by Islamic boards.

The Shariah boards are appointed by the banks. They are very costly and can trigger conflicts of interest when the advisers try to keep the business of the banks that are paying their fees running.

However, in response to this conflict of interest some countries like Malaysia and Bahrain came up with other types of boards. They are constituted by regulators who appoint a Shariah board who is responsible of vetting the legality of the instruments^107(*).

This process can be judged slow but more transparent.

However, the industry which is growing faster is suffering from a lack of qualified scholars, which put in question the professionalism of the qualified opinion obtained.

Also this situation can generate conflicts of interests due to the fact that the same scholars can assist the Shariah boards of two competitors.

Some countries like Malaysia have tried to sort this lack by training scholars but the process is slow and costly.

e) Lack of uniformity of Shariah standards

The existence of different Shariah boards and different Shariah opinions promotes inconsistent interpretation and application of Shariah rules. A contract can be legal in one jurisdiction (like lease and sale back) and completely illegal in the others.

The lack of Shariah scholars of high standards is a major problem is Islamic finance. Shariah scholars can be counted as 60 worldwide and earn high fees. They also sit on the boards of several different companies most often competitors which lead to a massive conflict of interest^108(*).

The work of AAOIFI (which gathered scholars from different schools) or the example of Malaysia which created a unique Shariah board supervised by the central Bank^109(*) are very effective measures towards standardisation but not sufficient.

f) Limited supply and inadequate financing

The Islamic financial institutions need a secondary market for Islamic financial instruments.

Their financial ratios are pretty high. However, the inability to invest the money affects their benefits and their competitiveness.

The creation of a secondary market in Pakistan is a good step on the right path^110(*).

It helps Islamic institutions seek liquidity in case of shortage.

In order to be resilient to the crisis, Islamic banks must have access to an Islamic lender of last resort. They are now bound by the law of necessity to accept central banking findings; an interest free solution must be purported.

g) Tax issues

Shariah compliant structures often involve double contracts usually on assets.

The possibility of tax liabilities is a negative point in the growth of the industry that is unable to compete with conventional counterparts.

«Property tax, gain tax, stamp duty tax need to be assumed in a neutral way between Islamic and conventional so they won't be any path of innovation»^111(*).

In the United Kingdom, stamp duty has been removed by the Bill 2009 which is still waiting for the royal assent^112(*).According to an analysis published on Deloitte's site, «Finance Bill 2009 will introduce relieving measures for stamp duty land tax, capital gains and capital allowance rules for land transactions involved in connection with the issuance of sukuks. The changes are intended to remove the previous tax barriers that essentially prevented the issuance of real estate backed sukuk by UK corporate - thus enabling sukuks to be held, issued and traded without incurring stamp duty land tax and corporate tax costs over and above that which would be incurred in connection with similar dealings in traditional corporate bonds».

h) Lack of authenticity

All these disadvantages affect the authenticity of the Islamic finance as conform to the Shariah spirit!

2) General lessons to be learnt

After establishing the advantages and disadvantages of the Islamic financial system, it is now clear that such a system cannot constitute an alternative to the current system. Its resilience to the crisis in general can help to extract lessons to be learnt from it. However these lessons are joined to other general lessons which need to be explained to enhance the current financial architecture. After the exposition of the general lessons or improvements to the system, a more specific analysis will be conducted to see the lessons we can learn from Islamic practices specifically.

A) General lessons to be learnt from the crisis^113(*)

A lot of studies tried to conclude lessons to learn from the financial crisis. Some propositions to deal with the financial crisis must be linked to the causes. According to Professor Georges Walker: `'the core causes of the crisis can be summarised in term of credit accumulation, product complexity, incorrect valuation, risk separation, and ineffective central bank and liquidity support».

a) Credit accumulation

Excessive money and excessive lending lead to a rise in assets price. Coordination between fiscal authorities and regulators concerning interest rate management or the restriction of certain products can limit the formation of bubbles which would not burst. Cheap credit which does not reflect the customer ability to repay is a problem and the credit risk must be evaluated before lending.

b) Product innovation

Product innovation is necessary. However, this innovation must not exceed the capacity of the bank to manage the risks. «We only innovate what we can manage»

The co-mingling of toxic debts with good assets was like putting a bad apple in a box of good ones. It infects the entire box. This must be controlled.

c) The liquidity support

The liquidity of the bank assets must be controlled. Investing in bonds because of their higher return was wrong policy. The secure investment in government bonds is more recommended.

d) Asset valuation

Under Basel II the reliance on the rating agencies was so important. Their role needs to be minimised. The mark to market rule must be suspended in crisis time created to strengthen the supervision this rule tends to be procyclical. It leads institutions to show temporary deficits on their balance sheet which lead to panic under stress time.

e) More transparency and accountability

Transparency means the provision of relevant information in a complete way within a reasonable lapse of time. The lack of transparency led to panic. The complexity of the products and the ignorance of who might be exposed to them led to the interbank crisis and to the panic of investors.

B) Lessons to be learnt from Islamic finance

Number of ethical Islamic rules is relevant to the crisis. The asset backed financing, the prohibition of sale of debt, transparency and certainty in contracts played a very important role in the escape of Islamic institutions from the crisis. These ethical values can be transmitted into the conventional system in order to make them resilient to shock waves'^114(*)

a) A shift versus a more conservative model

According to Rodney Wilson, «the soundness of Islamic banks is accounted by the fact that they are a classical bank model, with financing derived from deposits rather than being funded on the interbank market»^115(*). However, funding in the interbank market is not a problem especially that Islamic banks are thriving to have this type of lending. It helps banks obtain foreign currencies and extra lending. However, the extra reliance on this type of market like the Northern Rock system proves to be wrong. The establishment of a clearing house is recommended by Andrew Mc Knight would remove the credit risk exposure of banks to each other. Unlike conventional finance which generates money from money, Islamic finance is asset based^116(*).For this reason, money supplied via the Islamic financial techniques creates real assets. The use of low leverage rule helps control the amount of money in the system which leads to financial instability. A lesson to learn from Islamic finance is to shift steadily towards a low leverage more conservative model.

b) The limitation of speculation

Pure speculation made the headlines last year. The banking practice based on the «originate to distribute model» was motivated by the thrill to make profits. The financial crisis revealed the weakness of such system which can collapse under any default in underlying assets. The lesson to learn is to limit the scope of such operations which must meet the need of the borrowers. However, innovation must be encouraged to suit the financial need of the borrowers only and not for gambling purposes. Derivatives for instance can be used for hedging purposes only. According to Andrew Mc Knight, banks should go `back to reality `by not creating a virtual world not part of an underlying asset^117(*).

c) Risk participation

In Islamic finance, risk sharing replaces risk shifting. When participating in the risks, the fund provider will give more importance to the productivity of the project. The credit worthiness of the client will come in a second degree. However, in the conventional system, the risk was shifted and no attention was gift to the credit worthiness of the client, one of the causes of the crisis.

d) Transparency and authenticity^118(*)

The role of the rating agencies was widely criticised in this article. ^119(*) The conflicts of interest and the mistake in assessing the crisis all reflect a non transparency endangered by a non accountability.

The need for more transparency in the system is urgent like the settlement of a national sharia board in some countries; a credit agency directed by regulators could be anticipated.

e) More regulation

The financial crisis put the emphasis on these off balance sheet funds (shadow banking and hedge funds) and instruments. «Better regulation is needed and in places tighter «^120(*) . In order to improve this issue regulation must be strengthened regarding collateral used by banks and financial ratios which must be increased.

f) Invest in financial literacy^121(*)

Financial awareness should be raised between citizens. A large numbers of home owners insist on the fact that if they were better advised they wouldn't have invested. Awareness to innovation and to risks should be monitored in classes in high school ^122(*)

g) The Widespread of Islamic justice

Islamic objectives are to spread justice in the society. For this reason, if a borrower cannot pay his debt, the Islamic rule requires giving him time in order to repay. The use of these techniques by current banks helps prevent the bankruptcy of a lot of depositors^123(*). This morality in operations has reduced the «animal spirit `in all the people and help them consider the good of the society on the long term. This was proposed by those who recommended the «adoption of a voluntary mortgage write-downs plan» ^124(*) .This justice requires that bonuses should not be paid in case of problems so employees can share the burden in bad times.

h) Prohibition of the payment of interest

Interest and inflation is the monster of our economy. If interest can be abolished, a lot of problems will be resolved^125(*).This is for sure is an extreme solution.

* 94 ^_ Robbin Wiggleworth, `Credit Crunch May the Industry Beliefs`(2009)Financial Times .<http://www.ft.com/cms/s/0/87d150ee-3836-11de-9211-00144feabdc0.html>

* 95 ^_ Hans Visser, Islamic Finance: Principles and Practice (2009) 134.

* 96 ^_ Muhamad Ayub, Understanding Islamic finance (2007) 452.

* 97 ^_ Ibid.

* 98 ^_ Hans Visser, Islamic Finance: Principles and Practice (2009) 135.

* 99 ^_ Muhammad Taqi Usmani, An Introduction to Islamic Finance (2000) 241.

* 100 ^_ Muhammad Saleem,Islamic Banking -a 300 billion $ deception(2006)introduction.

* 101 ^_ Don Sheelan,2003,p.7

* 102 ^_

* 103 ^_ Euroweek Jan 2009 Review of 2008.p99

* 104 ^_ Siddiqi, Current Financial crisis and Islamic Economies(2008)3

* 105 ^_ Hans Visser, Islamic Finance: Principles and Practice (2009) 138.

* 106 ^_ Umer Chapra ,Innovation and authenticity in Islamic finance, speech delivered at Eight Harvard University Forum on Islamic Finance, April 2008.

* 107 ^_ Michael Blair, Georges Walker, Robert Purves, Financial Services Law, (2008)2^nd edition, Oxford, chap 19.

* 108 ^_ Hans Visser, Islamic Finance: Principles and Practice (2009) 97

* 109 ^_ Hans Visser, Islamic Finance: Principles and Practice (2009) 97

* 110 ^_`Pakistan Islamic Banks look to kick-start interbank financial market' [31 July2009].

http://www.newhorizonislamicbanking.com/index.cfm?section=news&action=view&id=10790accessed 26 August 2009.

* 111 ^_ Michael Blair and G A Walker ,Markets and Exchanges Law (OUP,2006)

* 112 ^_ http://www.ukbudget.com/UKBudget2009/business/Budget09-business-islamic-finance-alternative-finance-investment-bonds.cfm

* 113 ^_

* 114 ^_ How to build a financial System more resilient to shockwaves, financial times 12 August 2009,

http://www.ft.com/cms/s/0/1b4f2794-86d7-11de-9e8e-00144feabdc0.html> Last accessed 14 August 2009.

* 115 ^_Rodney Wilson, «Why Islamic banking is successful? Islamic Banks are unscathed despite of the financial crisis», p.3

* 116 ^_ Muhamad Taqi Usmani,An introduction to Islamic finance, XVI

* 117 ^_ Andrew Mc Knight. A review of 2008, class seminar.

* 118 ^{_ _} Mark M Zandi, Financial Shock: a 360 look to the subprime mortgage crisis (2008)238.

* 119 ^_ Ft week End October 18/19 2008 Sam Jones when junk was gold.

* 120 ^_ Georges Cooper, The Origins of Financial Crisis,Vintage books,2008(VII)

* 121 ^_ Mark M Zandi, Financial Shock: a 360 look to the subprime mortgage crisis(2008)236.

* 122 ^_ Ibid

* 123 ^_ Ibid

* 124 ^_ Mark M Zandi, Financial Shock: a 360 look to the subprime mortgage crisis(2008)233.

* 125 ^_ Georges Cooper, The Origins of Financial Crisis, Vintage books,2008(43)