Saturday, February 21, 2009

Islamic finance and the global economic crisis

In search for the origins of the current financial crisis in the U.S, which led to global recession, economists observed that the flaws in the loan industry in the form of toxic subprime mortgage loans and the fraud committed by banks and non-bank lenders, in addition to insufficient regulations and standards in the loan industry have sparked the current economic crisis and shook investors’ confidence in the economy, resulting in further economic meltdown (Congressional report, 2009, p. 258-259).

Proponents of Islamic finance believe that if Islamic principles had been applied to Wall Street, the global economic crisis never would have happened (Power, 2009, p. 70). Islamic finance accounts for just 1 percent of the global market, with an annual growth of 15 percent (p. 72) and will continue to do so for at least the next decade (Di Meglio, 2007, p. 2). Khan, 2006 argued that many in the West are unaware of the richness and depth in which Islamic political economy deals with the important issues of poverty, debt, trade and land reform. An Islamic approach differs fundamentally with the current neo-liberal global paradigm as it is not shaped by a narrow monetary or utilitarian approach to human behavior (p. 252).

Islamic economists see the application of their ideas as a third way, neither capitalist nor socialist, but “drawing on the religion and traditions of the religion” (Wilson, 2002, p. 143). They added that there is neither an inherited conflict between western capitalism and Islamic economics, nor they represent competing ideologies. Moreover, Islamic finance should not be seen as alternative to capitalism, but rather source of evolution to fix and improve the current financial system. (p. 144)

The 2008 congressional report on the current financial crisis facing the US, attributed the causes of the financial turmoil to several factors, among them “rising defaults among residential mortgage borrowers sparked the initial loss in financial market confidence. Various observers place different emphasis on low interest rates that caused a housing bubble that in this view was bound to eventually burst, insufficient regulation of subprime mortgage lending practices, and insufficient monitoring of complex financial products and services, especially rating agencies and derivatives markets” (p. 258).

Furthermore, the report also emphasized on “loose lending standards that may have been fostered by a lack of regulation of non-bank lenders and a lack of market discipline by mortgage-backed securities issuers who sold the loans to other investors Another group places the blame on the failure of officials to regulate relatively recent innovations in finance. Still others emphasize potentially irresponsible marketing practices or fraud by subprime lenders. Some observers blame investors and borrowers who did not adequately investigate the risks of their decisions” (p. 259).

Moreover, according to the report, “Complexities of mortgage-related securities have made it difficult to ascertain their value; thus, those assets have become less liquid. Furthermore, investors know that some banks have suffered loan losses that reduced their capital, but the complexities of the mortgage-related assets have made it difficult to identify which banks are under-capitalized. As a result, the liquidity of mortgage related assets has been reduced, and the liquidity of financial firms has been reduced” (p. 259-260). “The result of this financial turmoil also affected anyone seeking credit, including homeowners who wish to refinance out of a troubled mortgage. Restrictions in credit have contributed to a downward spiral in home prices. The people most directly affected by financial market turmoil are investment bankers and investors. These people may lose their jobs and livelihood. Business firms are also affected because their cost of financing possible projects has risen, which in turn can hurt the broader economy” (p. 258)

Until the credit crunch of 2008, Islamic finance was a fast-growing, if still relatively obscure, new specialty of international finance. But after Wall Street’s implosion, Islamic finance’s champions began to promote the sector as a safe haven from the ills of the global economy (Power, 2009, p. 72). At a time of almost unprecedented financial volatility, and as the credit market imploded triggering global economic crisis; Islamic banks are being hailed as bastions of stability (Quinn, 2008, p. 1). Investors who did not invest in interest-based economy were mostly unharmed by investments in financial services companies, whose stocks have collapsed, and out of traditional mortgages (Kuruvilla, 2009, p. 1). Moreover, Dow Jones Islamic Market Indexes, which represent benchmarks for islamically correct investment categories, have been outperforming their non-Islamically compliant counterparts by 3 to 4 percent in key indexes (Kuruvilla, p. 1)

Therefore, a growing numbers of individuals and companies are now embracing their workings, which are based on Koranic principles (Quinn, 2008, p. 1). Today, there is an increasing number of financial products and services available that are compliant with Islamic finance. Rising petroleum prices, increased attention on the Middle East as a result of politics, and competition between Bahrain and Dubai for the title of Middle Eastern financial center are other factors contributing to the economic surge (Di Meglio, 2007, p. 2)


The resurgence of Islamic finance is seen by Islamists as an indication of the failure of capitalism. At a Doha conference in late 2008, Sheikh Yusuf al-Qaradawi, arguably the world’s most influential Islamic scholar asserted that “the collapse of capitalism . . . shows that the Islamic economic philosophy is holding up.” Yusuf Talal DeLorenzo, Islamic finance expert, is even more sweeping in his claims. “If you had sukuk [or interest free bonds based on actual assets], the subprime crisis never would of happened” he says (Power, p. 72).

In most Islamic countries, Islamic banking coexists with conventional banking. In some countries, for example Iran and Pakistan, Islamic banks are the only mainstream financial institutions. Islamic finance is also offered in Europe by a small number of conventional banks and through the recently established Islamic Bank of Britain (Chiu, Newberger, Paulson, p. 64)

Like political Islam, Islamic finance began as a search for authenticity and independence from the West (Power, p. 73). Add a booming Muslim middle class and non-Muslim eager to profit, and it is easy to understand why some of the world’s biggest banks are spending millions to enter the market. The 300 dedicated Islamic banks and funds worldwide, operating in 75 countries, are beginning to face stiff competition from top-tier global firms such as Deutsche Bank, HSBC, and Citibank (Power, p. 72). Islamic economists argue that imported economic systems have not worked in the Arab world, as the very poor economic performance of the twentieth century clearly demonstrates, but governments that are dependent on western financial support and accountable at least in some degree to international institutions such as the MF and WTO are increasingly isolated from important sections of their own populations (Wilson, 2002, pp. 143-144)

According to Chiu, Newberger and Paulson, 2005, Islamic finance is the act of providing financial products or services that conform to Islamic law, which is based on a profit and loss structure rather than a lender-borrower arrangement. A profit and loss structure requires that a financial institution enters into a joint venture with a client in order to provide capital. The risk associated with the joint venture entitles the financial institution to profit from the financial transaction (p. 64)

In principle, Koran requires Muslims to share the risk of an investment while sharing the prospect of profits and prohibits contracts in which one party must repay a certain amount of money in a specific amount of time (Goffe, 2001, p. 1). Therefore, as Qutub in 2008 explained, money cannot be sold for more money (i.e. charging an interest for a loan). Loans are strictly meant for charity and not as investments. As a result, investment contracts are never currency-based, rather asset-backed or based on commodities. This would mean one would have to be more involved in an actual investment, either partnering with the individual who is looking to purchase a commodity, or buying a stake in an organization on is choosing to assist (p. 1)

Another basic tenet of Islamic finance is that Sharia law prohibits investing in morally questionable companies, such as enterprises involved with alcohol, gambling, tobacco, and pornography (Quinn, 2008. P. 1& Power, 2009 p. 70) and debt can't exceed 30% of equity (Balfour, 2008, p. 1)

Carla Power in her article “faith in the market” explained eloquently the basics of Islamic finance. She stated that the central concept in Islamic finance is justice, and explained how risks must be shared. In other words, transactions that could be unjust for either the borrower or the lender are discouraged (Power, p. 73). Furthermore, a big part of the appeal of Islamic finance is its simplicity. Speculation is taboo under Islamic law, and there's a ban on assessing interest because the Prophet Mohammed said debts must be repaid in the amount that was loaned. Money proffered must be backed by collateral, and if financial instruments are traded, they generally have to sell for face value, which deters banks from repackaging debt (Balfour, p. 1). Therefore, money cannot be invested in financial derivatives or debt products (Chiu, Newberger, & Paulson, 2005, p. 66). Islamic finance prohibits selling assets you don't own, selling someone's debt and engaging in high-risk investments. Thus, there was no participation in practices that have been blamed for Wall Street's meltdown: complex derivatives trading, short-selling and the $30 trillion market in credit default swaps (Kuruvilla, p. 1)

To get around the Koran’s ban on interest, Power, 2009, explained how the Islamic banking has relied heavily on what is called murabaha: a loan or sale in which a markup is added to the transaction’s cost. So when a Muslim borrower goes to a bank to buy a car or a house, he/she agrees to a contract in which he pays the cost of the item, plus a certain amount of profit. The bank is technically a partner, rather than a just a financier (p. 73). For example, According to Goffe, 2001, a prospective home owner is required to put down 20 per cent of the home purchase price and enter into a 10-year lease with an option to buy. The prospective home owner's monthly rental payments will cover the mortgage, tax and insurance payments on the property. The homeowner may buy the home during the lease term. At the end of the lease term in 10 years, the home owner may extend the lease and purchase an option for an additional 7 years (Goffe, 2001, pp. 2-3). When the deed of transfer is finally given to the borrower, the bank gets a slice of the home's increased value - or take a loss if the price has gone down (Kuruvilla, p. 2).The lease allows the prospective home owner to benefit from price appreciation at any time by exercising the purchase option and then selling the property to a new home buyer (Goffe, 2001, pp. 2-3). However, homeowners who bought homes through an islamically compliant lender don't have to worry whether their lender will work with them if they lose their jobs. Islamic lenders are required to work in good faith with distressed borrowers to figure out ways to make payments manageable - and co-op leaders say they will (Kuruvilla, p. 1). Moreover, recession has had would have no impact on homeownership for reasons that have much to do with an Islamic requirement that the lender and the borrower share the risks and rewards of a loan (Kuruvilla, p. 2)

An Ijara, or Islamic lease, according to Power, allows a bank to buy a car or a house for a customer and then earn a profit by renting it to them. An Islamic investor who wants to start a business can go to a bank and embark on mudharaba, or partnership, in which the bank supplies the money and the customer, brings the business skills. Profits are shared in a predeterimental ratio; losses are borne by the bank. For insurance, companies offer policies in which a group of subscriber creates a pool of funds that can then be invested and drawn on in cases of legitimate claims. Unclaimed profits are then distributed among policyholders (Power, p. 73)

The Musharaka transaction is a declining balance or shared equity purchase. Whereby the financial institution provides a percentage of the capital desired by the client. The financial institution and the customer proportionately share in profits and losses in accordance with a formula agreed upon before the transaction is completed (Chiu, Newberger & Paulson, p. 66). Even depositors at Islamic banks are supposed to share profits and losses with the bank, instead of receiving interest payments -- an arrangement that U.S. banking regulators have so far balked at approving (Wiseman, 2008, p. 2)

These methods are believed to meet the spirit of the law because they avoid the exploitation of the borrower. Under this model, Islamic banks have created scores of financial products for Muslims to avoid Western-style interest of risk. The result is a parallel system of Islamic offerings that mirror those available from conventional banks: Islamic mortgages, Islamic car loans, Islamic credit cards, and Islamic insurance (Power, p. 73)

According to a new study by International Financial Services London (IFSL), an independent organization representing Britain's financial services industry, Islamic finance will emerge largely unscathed from the current global crisis, largely because its structures make little or no use of many of the complicated instruments blamed for the current problems in conventional finance, such as derivatives and short-selling.(Quinn, 2008, p. 1).

Therefore, Muslim investors haven’t suffered from falling bank stocks because the Koran bans investment in financial institutions. Since the Koran bans gambling, the related practice of risk is forbidden. So too is the short-selling of stocks (on the grounds that you can’t sell what u don’t own) and the sale of debt. Indeed, the practice of repacking and trading debt, as well as credit-default swaps, both so central do the financial crisis, never could have happened under Islamic law (Power, p. 73).

Islamic finance experts and investors caution that the crisis doesn't mean that Islamic finance is a better model than Western capitalism. They say Islamic finance, a system of ethical finance supported on an institutional level, provides unique insight into an economic meltdown created in part by financial practices forbidden by strict observance of Islam (Kuruvilla, p. 1)

For investors in stocks, Islamic finance doesn't differ dramatically from Western principles.. Such rules leave more than half the companies in the Standard & Poor's 500-stock index--including Microsoft, Southwest Airlines, and Nike--in compliance. "You can be an ethical investor without being Muslim," says Arne Lindman, CEO of Prudential Fund Management in Asia.

Indeed, an increasing number of non-Muslims are becoming more interested in Islamic loan products. Half of HSBC’s Islamic mortgages in Malaysia went to non-Muslims the first year the company offered them . . . All of which raises the ironic possibility that Islamic finance, in its quest to develop a more spiritually pure alternative to modern materialism for the world’s Muslims, may have ended up creating a large and attractive market for Western investors (Power, p. 74).

On other hands, emerging economies in Islamic countries have also benefited from western economic models. Onis in 1997 gave an example of the Turkish Welfare Party (pro-Islamic), which was striking to observe how the party has been heavily influenced by the successful models of East Asian capitalism. Looking towards the East for a broad model of development, the hierarchic, semi-authoritarian models of capitalism in East Asia and Southeast Asia, with a strong communitarian element, appear more congenial from an Islamic perspective compared to Western models of capitalism and their associated emphasis on individualism, secularism and liberal democracy . The Welfare party presented itself as more Eastern-orientated, heavily influenced by the successful cases of East and Southeast Asian capitalism and finding close affinities between the communitarian traditions of Islam and the communitarian features of the Asian models (p. 760). In fact the Welfare Party as the political expression of rising Islamic capital reflects the cooperative attempts of these groups to obtain a large share of the benefits associated with globalization . Onis therefore concluded that the mechanisms of economic globalization and the associated process of neoliberal restructuring have been instrumental in the rise of the pro-Islamic Welfare Party to a position of prominence in the mid-1990s (p. 763)

Therefore, as Wilson in 2002 argued, it might be misleading and indeed mistaken, to take the view that there is an inevitable conflict between western capitalism and an Islamic economic system and that the two represent competing alternatives. Both systems are evolving, and both encompass many variants. The juxtaposition of Islamic economics and western capitalism has yet to be determined in the Arab world, and indeed indigenous capitalism has already taken on some features that are consistent with Islamic economic principles and may well take on more (p. 144).

Furthermore, the rejection of integrating Islamic economic models into western capitalism will eventually force Islamic countries seeking to adhere to Islamic laws into forging regional integration among other Islamic countries. The European refusal to admit Turkey to the European Union has resulted in the Welfare Party’s strong rejection of the Customs Union with Europe and a corresponding emphasis on the need to reorient the country's economic relationship and foreign policy stance away from the West towards a closer union with the Islamic world. A number of the association's research publications investigate the potential benefits to be derived from closer cooperation between Turkey and other Islamic countries. As part of its grand strategy involving a closer union with the Islamic world, the organization has also formulated concrete projects for economic union among Islamic countries (Onis, p. 759)

And as Khan in 2006 put it, the neo-liberal world may have delivered technological transformation and selective economic prosperity but it has lost its moral compass and therefore fitness to lead mankind on this problem. Within neo-liberal societies there is now growing individualism, a huge spiritual deficit, and an unethical foreign policy. The time is ripe for a serious and rational debate to take place as to the suitability of alternative paradigms to neo-liberalism, such as the Islamic political economy or those that are now being implemented in Latin America and South East Asia (p. 254)

That doesn't mean Islamic finance won't suffer in an economic downturn. As some economists argued, since they must hold collateral; Islamic financial institutions tend to have more real estate assets than Western banks do. So far, sharia-compliant banks--mostly in the Gulf region--haven't suffered because housing prices there have held up relatively well. But if those markets were to dive, there could be trouble (Balfour, 2008, p. 1). However, a globalized market means Islamic investments are exposed along with mainstream ones. According to Standard & Poor’s, Sharia-compliant stocks lost 23 percent of their value during the first three quarters of 2008, compared with a 25 percent fall for non-Sharia-sanctioned stocks. And Islamic finance, just like conventional finance, is vulnerable to sloppy vetting of customers’ creditworthiness. Potential pitfalls for Islamic finance, then, are the same as those for conventional finance: greed and lax regulation (Power, p. 74). But performance alone isn't the point of compliance with Islamic law, known as Sharia. For the committed, investing finance with faith is about living with values (Kuruvilla, p. 2)

Critics of Islamic finance also argued that the majority of so called Sharia products do not uphold pure Islamic principles. One recent study concluded that 85 percent of bonds marketed as Sharia-complaint were illegitimate. Mahmoud El-Gamal, a professor at Rice University and author of Islamic Finance: Law, Economics, and Practice stated “There’s a whole industry now—supported by a show of religious authority provided by Islamic scholars—with banks promoting conventional products as Islamic” (Power, p. 72)

Moreover, as Chiu, Newberger and Paulson argued, providers of Islamic finance in the United State’s face two principal challenges. One challenge is to offer products that conform not only to Islamic religious doctrine, but also to state and federal regulations. Islamic finance is sometimes better understood by the banks and finance experts who have developed and marketed the Islamic finance products than by the regulators whose approval they need. The second challenge for financial institutions involves the cost of offering new products that have little precedent in the United States.( p. 65). Moreover, While Islamically correct investing is a booming industry, Islamic financial products tend to generate less profit on a per transaction basis than conventional products. Although, for most of the providers, the volume of these sales bas compensated for the increased costs. The Iman Fund, run by Allied Asset Advisors and one of the largest Islamic mutual funds in the country, has performed worse than the S&P 500 and others in its category, according to Morningstar, a mutual fund rating service (Kuruvilla, p. 2)

Chiu, Newberger & Paulson added that further potential cost relates to the sale of Islamic financial products in the secondary market. Opportunities for selling assets on the secondary market may be limited, which is more likely to affect the appeal of these products both to Islamic investors and to financial institutions.

Furthermore, opponents of Islamic finance also described it as “religious hypocrisy”, where scholars can come up with fatwas (religious decree) to suit the needs of their local governments or large business corporations (Wilson, 2008. p. 153). Such contradicting and often confusing religious regulations pose another challenge for Islamic finance. Wiseman, 2008, explained how scholars at the Al-Azhar Institute in Cairo -- influential in Islam's chief Sunni denomination -- declared in 2002 that the Quran did not prohibit all interest payments and charges (p. 2), and that the interest paid by conventional banks on deposits should be regarded as profits rather than usury or riba [usury] (Wilson, 153). The implication of this ruling was that there was no difference between Islamic and conventional banks which have been widespread for years in the Islamic world. A stricter interpretation -- barring all interest -- has been gaining ground over the past decade and driving the growth of no-interest Islamic finance (Wiseman p, 2). The Fiqh Academy in Jeddah being much more respected throughout the Sunni Muslim World, including fatwa that all interest recipients or payments constitute riba and are therefore prohibited (Wilson, 153)

Another hurdle for Islamic finance even in Islamic countries is the perception that Islamic finance is seen as part of a wider agenda by political Islamists, which could threaten and undermine the state itself (Wilson, 143). Although most Arab governments have been prepared to tolerate Islamic banking, but apart from the Sudan, there has been no attempt to convert the conventional banking system to Islamic financing methods through the enactment of legislation prohibiting riba (p. 145). Both the Egyptian and Saudi Arabian governments have been reactive rather than proactive towards Islamic finance, with much indecision as to how best to respond to these experiments in applying Sharia law to modern finance (p. 167).

Moreover, Carla Power in 2009 stated that the industry’s chief critics see in Islamic finance the same rhetorical spin as Islamist politics. “The whole idea of giving [finance] a religious identity is just a form of identity politics,” says El-Gamal. “The claim that Islam has the perfect solution is questionable in economics, just as in politics.” Still others see outright deception. Mohammad Akram Nadwi, a prominent Britain-based scholar of Islamic jurisprudence, advises his students against taking out Islamic mortgages, because he thinks their structure is merely interest-bearing debt in disguise. “At least conventional mortgages are honest,” he shrugs. (p. 75). Indeed, Al-Rajhi and the National Commercial Bank , larges investment bank in Saudi Arabia for example, offer sharia compliant mutual funds to Saudi Arabian investors by, but much of the investments are in the US (Wilson, p. 161)

To conclude, principles of Islamic finance in interest-free loans carry a solution to some of the problems that led to the current financial crisis. However, Islamic finance should not been considered as alternative to capitalism, but rather an innovation to fix the current economic crisis and prevent future ones. Islamic finance and capitalism are not two competing models of economics; they both are evolving in ways that can benefit each other. Indeed indigenous capitalism has already taken on some features that are consistent with Islamic economic principles and may well take on more. A larger issue is whether Islam and the modern economy can be reconciled at all. Is it enough to create banking products that mimic those of traditional finance but also meet the letter of Islamic law? (Power, p. 75). Western governments may find it difficult to enforce Islamic social norms and are against aspects of Islamic criminal law, but there is more scope for co-operation in the economic and financial field (Wilson, p. 144). If Islamic culture and identity can be preserved in a globalized world (Mansour, 2008), then, adopting some of the principles of Islamic finance will strengthen the International Political Economy by fostering the integration of the Islamic world into global economy.

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