Transcript Financial Crisis: Lessons for Islamic Finance

Global Financial Crisis:
Lessons from Islamic Finance
and Implications for Local
Business
Prof. Habib Ahmed
Durham University
Agenda

Background

Islamic Principles and Law Related to Finance

Financial Crisis—Build Up

Lessons from Islamic Finance

Implications for Local Business

Conclusion
Islamic Commercial Law:
Basic Approach



In economic transactions (muamalat), all
activities are permitted expect what is explicitly
prohibited by Islamic law (principle of
permissibility)
New transactions can be accommodated through
ijtihad as long as they do not contain the
prohibited
The prohibitions in transactions include:


Riba
Gharar
Riba

Riba (literal meaning ‘increase’) is
prohibited
“...they say: trading is only like riba, whereas God has
permitted trading and forbidden riba…” (Quran 2:275)
Different types of riba
 Implications of riba:



Interest is forbidden
Selling debt is not allowed
Gharar
Gharar–Excessive risk, hazard, or
ambiguity
 Gharar can exist in the object or terms of
the contract
 Implications of gharar:

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Existence of the object (& ability to deliver)
The future sale
Derivative instruments (options, swaps,
forwards, etc.)
Agenda

Background

Islamic Principles and Law Related to Finance

Financial Crisis—Build Up

Lessons from Islamic Finance

Implications for Local Business

Conclusion
Making of the Crisis (1)
1.
Driven by excessive profit-motives,
banks/financial institutions engaged in subprime lending (with adjustable interest rates)
2.
Loans packaged as Mortgage Backed
Securities (MBS)/Collateralized Debt
Obligations (CDO)
•
•
3.
55% of the $10.2 trillion loans securitized (end 2006)
12-15% of securitized loans were sub-prime
Rating Agencies gave positive ratings to these
securities (to get more business and collect
fees)
Making of the Crisis (2)
4. Investors (banks, hedge and pension funds,
municipalities, schools, etc.) acquired these
securities
5. Investors/speculators bought Credit Default
Swaps (CDS) to hedge credit risks on
MBS/CDO
•
Notional amounts of OTC Derivatives in 2007 $596
trillion, CDS $58 trillion (US GDP $13.8 trillion)
6. Issuers of CDS (Investment banks &
Insurance companies) took on the risk of
default
From Defaults to Economic
Meltdown



Interest rates began to rise (1% to 5.25% between 20042006)
Adjustable rate subprime loans started to default
Holders of MBS/CDO incurred losses



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Issuers of CDS had to pay-off the losses caused by default
Losses caused depletion of capital of FIs
Scramble to get funds

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Prices of CDOs fell
Money market froze (as lenders did not know the risks
involved)
Lack of financing caused housing market to crumple—
further decreasing housing (CDO) prices and increasing
market risks
Credit risks, market risks, and liquidity risks produced
systemic risks
Vicious cycle of deleveraging and economic downturn
Agenda

Background

Islamic Principles and Law Related to Finance

Financial Crisis—Build Up

Lessons from Islamic Finance

Implications for Local Business

Conclusion
Islamic Financial Principles and Crisis

Islamic principles:

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Prohibition of selling of debt (CDOs)
Prohibition on derivatives (CDSs)
Prohibition on short-selling—limiting betting on
downside risks
Using risk-sharing instruments—more
monitoring
If Islamic principles were followed, the
crisis would not have taken place the way
it did
Crisis and Islamic Finance:
Ethical and Legal Dimensions
1.
2.
3.
4.
5.
Conventional
1.
Banks/financial
institutions engaged in
sub-prime lending
Loans packaged as
2.
MBS/CDO
Rating Agencies gave
3.
positive ratings to these
securities
Investors/speculators
4.
bought securities
Credit Default Swaps
5.
(CDS) to hedge/speculate
on credit risks
Islamic
[Risk–sharing modes preferred]
[Excessive greed discouraged]
Selling of debt prohibited
[Dishonesty discouraged]
-
Derivatives prohibited
[Speculation discouraged]
Islamic Financial Sector and Crisis

Islamic financial sector has performed
relatively better under the crisis
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‘While conventional banks worldwide are nursing losses
of more than $400 billion from the credit crisis, Islamic
banks are virtually unscathed ’ (IHT, August 19, 2008)
‘In a dire year for mutual funds, the Amana Trust
Income Fund, the main Muslim investment fund, has
trumped those from all other faiths in the US by losing
only 25.8% of its value for the year – half the average
44% loss for the US stock funds’ (FT, Dec. 26, 2008)
‘Non-Muslims turn to Islamic Bank as a safe option’
(Birmingham Post, Oct. 3, 2008)
‘Shares of most Islamic Banks in GCC markets record
spectacular rise’ (Arab News May 14, 2009)
Agenda

Background

Islamic Principles and Law Related to Finance

Financial Crisis—Build Up

Lessons from Islamic Finance

Implications for Local Business

Conclusion
Implications for Local Business
The rationale of Islamic finance in UK—
social inclusion by providing financial
access to Muslim community
 Main beneficiaries are expected to be
Muslims who did not deal with
conventional finance
 Birmingham has a large Muslim
community that can be served by Islamic
finance

Implications for Local Business
Islamic finance is not for Muslims only
 Malaysia—Non-Muslims form a large
customer base for Islamic finance


Kuwait Finance House’s Malaysia—40 percent
depositors and 60 percent borrowers are nonMuslims
Other than ethical dimension, Islamic
finance can offer economic value that can
benefit all
 Islamic finance can supplement and enrich
the financial system

Implications for Local Business
Time of crisis—people looking for stability
and financing
 IF should offer something unique

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Protection
Stability
Risk Sharing
Economic value
Social inclusion
If the range of Islamic financial products
can be expanded—can attract more
customers
Challenges and Constraints
Instead of developing products in line with
the principles and values of Islamic law,
Islamic finance appears to be mimicking
conventional
 Image—information about Islamic
products and value proposition
 Birmingham-moving from a manufacturing
to a service based economy
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Retail, tourism, hospitality, transportation, etc.
IF have to come up with solutions to
provide financing to the service sector
Conclusion
After the crisis, conventional economics is
looking for ideas to fix the system
 Principles of IF has much to offer
 IF has features that can provide stability
and resilience during crisis
 Image—IF need to focus on the economic
value proposition
 Need to come up with new products that
serves the needs without compromising on
the principles

Thank you!
[email protected]