PPPPPPTHE GLOBAL FINANCIAL CRISIS: THE GLOBAL FINANCIAL CRISIS:

CAN ISLAMIC FINANCE HELPCAN ISLAMIC FINANCE HELP??

bybyM. UMER CHAPRAM. UMER CHAPRAResearch AdvisorResearch Advisor

Islamic Research and Training InstituteIslamic Research and Training InstituteIslamic Development BankIslamic Development Bank

Jeddah, Saudi ArabiaJeddah, Saudi Arabia

1.1. INTRODUCTIONINTRODUCTION

The prevailing crisis is the most The prevailing crisis is the most severe link in a chain of crises over severe link in a chain of crises over the last four decades the last four decades

Can anything be done to minimize Can anything be done to minimize the frequency and severity of such the frequency and severity of such crises in the future?crises in the future?

This is not possible without first This is not possible without first analyzing the primary cause/s of the analyzing the primary cause/s of the crisescrises

2. 2. The Primary CauseThe Primary Cause• Excessive and imprudent lending?Excessive and imprudent lending?• Why is this possible?Why is this possible?

o Inadequate market discipline?Inadequate market discipline?o Inadequate regulation and Inadequate regulation and

supervision?supervision?

33 . .HAS THE FINANCIAL SYSTEM HAS THE FINANCIAL SYSTEM FAILED ON BOTH THESE COUNTSFAILED ON BOTH THESE COUNTS?? Why?Why?

• When does the market operate effectively?When does the market operate effectively? The role of incentives and deterrentsThe role of incentives and deterrents

• False sense of security against loss?False sense of security against loss? Is it because of collateral? NoIs it because of collateral? No

• Sale of DebtSale of Debt• Securitization: Asset-backed Securities (ABSs) or Securitization: Asset-backed Securities (ABSs) or

Collateralized Debt Obligations (CDOs)Collateralized Debt Obligations (CDOs) Mixing of prime and subprime debtMixing of prime and subprime debt Lack of transparencyLack of transparency FraudFraud

o Emergence of Credit Default Swaps (CDSs)Emergence of Credit Default Swaps (CDSs) The role of wageringThe role of wagering

o Failure of rating agenciesFailure of rating agencieso Concept of Concept of ‘‘too big to failtoo big to fail’’o SupervisorsSupervisors’’ failure failure

44 . .SALIENT FEATURES OF THE SALIENT FEATURES OF THE ISLAMIC FINANCIAL SYSTEMISLAMIC FINANCIAL SYSTEM

Justice: hallmark of Islamic teachingsJustice: hallmark of Islamic teachings• Risk-sharing: Risk-sharing: ““No risk, no gainNo risk, no gain””• Equitable allocation of CreditEquitable allocation of Credit

Greater emphasis on equity and profit and Greater emphasis on equity and profit and loss sharing (pls)loss sharing (pls)

• Will make banks more cautious in lendingWill make banks more cautious in lending What about debt?What about debt?

• Debt is not created through direct lending and Debt is not created through direct lending and borrowing but rather through the sale and purchase borrowing but rather through the sale and purchase of real goods and servicesof real goods and services

55 . .CONDITIONS FOR DEBT FINANCINGCONDITIONS FOR DEBT FINANCING

1.1. The asset being sold or leased must be The asset being sold or leased must be real and not notional or imaginaryreal and not notional or imaginary

2.2. Seller must own and possess the assets Seller must own and possess the assets being sold or leasedbeing sold or leased

3.3. The transaction must be a genuine The transaction must be a genuine trade transaction with the full intention trade transaction with the full intention of giving and taking deliveryof giving and taking delivery

4.4. The debt cannot be sold: The risk of The debt cannot be sold: The risk of default associated with it must be borne default associated with it must be borne by the lender himself. This will motivate by the lender himself. This will motivate him to be more careful in lending. Will him to be more careful in lending. Will help prevent fraud?help prevent fraud?

66 . .IMPLICATIONSIMPLICATIONS

The market discipline that Islam imposes The market discipline that Islam imposes will put a check on excessive expansion will put a check on excessive expansion of debt.of debt.

The person who is going to suffer the loss The person who is going to suffer the loss is the best one to provide the disciplineis the best one to provide the discipline

Regulation and supervision are necessary Regulation and supervision are necessary but not sufficientbut not sufficient

o Regulation and supervision can be inadequateRegulation and supervision can be inadequateo Without moral consciousness regulations may Without moral consciousness regulations may

be circumventedbe circumventedo The supervisor can be negligentThe supervisor can be negligent

77 . .A PROBLEMA PROBLEM

The discipline will deprive the The discipline will deprive the subprime borrowers of creditsubprime borrowers of credit

Therefore, some arrangement needs Therefore, some arrangement needs to be made for making credit available to be made for making credit available to themto them

The market is profit-oriented and may The market is profit-oriented and may do this only to a limited extentdo this only to a limited extent

Role of the government and the Role of the government and the private sector altruismprivate sector altruism

88 . .ISLAMIC FINANCE IN ISLAMIC FINANCE IN PRACTICEPRACTICE

Islamic finance is still in its infancyIslamic finance is still in its infancy• PLS: small sharePLS: small share• Debt: major share Debt: major share –– every effort is every effort is

being made to transfer the risk to the being made to transfer the risk to the borrower or the lesseeborrower or the lessee

• The emergence of The emergence of tawarruqtawarruq has partly has partly severed the link with the real sector severed the link with the real sector

• Reason:Reason:• Absence of shared institutions to support Absence of shared institutions to support

the systemthe system• The The maqasid al-Sharimaqasid al-Shari‘‘ahah are not taken into are not taken into

account while giving account while giving fiqhifiqhi verdicts verdicts

99 . .SOME SUGGESTIONS FOR REFORM OF SOME SUGGESTIONS FOR REFORM OF THE INTERNATIONAL FINANCIAL THE INTERNATIONAL FINANCIAL

SYSTEMSYSTEM1.1. Raise the share of equity and lower that of debt Raise the share of equity and lower that of debt

in total financingin total financing2.2. Control leverage Control leverage 3.3. Allow credit primarily for promoting Allow credit primarily for promoting

development of the real sectordevelopment of the real sector4.4. Require banks to hold debt until maturity to Require banks to hold debt until maturity to

motivate them to ensure careful underwriting motivate them to ensure careful underwriting –– If, however, debt is to be sold, there must be full If, however, debt is to be sold, there must be full transparency along with right of recourse. If not, transparency along with right of recourse. If not, the issuer must hold a meaningful proportion of the issuer must hold a meaningful proportion of it it

5.5. CDSs should not be allowed to become CDSs should not be allowed to become instruments for wagering instruments for wagering

6.6. All financial institutions must be regulatedAll financial institutions must be regulated7.7. Some arrangement must be made to enable the Some arrangement must be made to enable the

subprime borrowers to get creditsubprime borrowers to get credit

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