Is Islamic Finance Panacea for Global Credit Crisis?

“Islamic finance can also reduce the problem of subprime borrowers by providing them loans at affordable terms. This will save billions of dollars that are spent to bail out the rich bankers,” said Chapra, who at present works as adviser at the Islamic Research and Training Institute of the Islamic Development Bank.

Chapra estimated the derivatives market at $600 trillion, more than 10 times the size of the world economy.

“No wonder George Soros described derivatives as hydrogen bombs while Warren Buffett called them financial weapons of mass destruction,” he pointed out. The derivatives include credit default swaps (CDS) worth $54.6 trillion.

The Islamic economist described the present global financial crisis as the worst in four decades. “There is a lurking fear that this might be only the tip of the iceberg. A lot more may come if the crisis spreads further and leads to a failure of credit card institutions, corporations, and derivatives dealers,” he warned.

Chapra urged Muslims to establish a genuine Islamic finance system with proper checks and controls, adding that such a move would encourage others to embrace it.

The Islamic system does not allow the creation of debt through direct lending and borrowing. It rather requires the creation of debt through the sale or lease of real assets by means of its sales- and lease-based modes of financing such as murabaha, ijara, salam, istisna and sukuk.

Spelling out the regulatory regimes in the Islamic system, Chapra said: “The asset which is being sold or leased must be real, and not imaginary or notional; the seller must own and possess the goods being sold or leased; the transaction must be genuine with the full intention of giving and taking delivery; and the debt cannot be sold and thus the risk associated with it cannot be transferred to someone else.”

He said the conditions set by the Islamic system would help eliminate most of speculative transactions. “Financing extended through the Islamic products can expand only in step with the rise of the real economy and thereby help curb excessive credit expansion,” he said.

Chapra emphasized the significance of the condition that prevents a creditor from transferring the risk to someone else by selling the debt. “This will help eliminate a great deal of speculative and derivative transactions where there is no intention of giving or taking delivery. It will also help prevent an unnecessary explosion in the volume and value of transactions and the debt from rising far above the size of the real economy,” he added.

It will also release a greater volume of financial resources for the real economic sectors and, thereby, help expand employment and self-employment opportunities and the production of need-fulfilling goods and services.

The discipline that Islam wishes to introduce in the financial system may not materialize unless the governments reduce their borrowing from the central bank to a level that is in harmony with the goal of price and financial stability, Chapra said.

“In the Islamic system, credit is primarily for the purchase of real goods and services which the seller owns and possesses and the buyer wishes to take delivery. It also requires the creditor to bear the risk of default by prohibiting the sale of debt, thereby ensuring that he evaluates the risk more carefully,” he explained.

He said excessive and imprudent lending by banks was the main cause of the current global crisis.

“There are three factors that make this possible: inadequate market discipline in the financial system resulting from the absence of profit and loss sharing (PLS); the mind-boggling expansion in the size of derivatives, particularly CDSs; and too big to fail concept of banks who believe that the central bank would come for their rescue.”

The false sense of immunity from losses introduces a fault line in the system as banks do not undertake a careful evaluation of their loan projects. This leads to an unhealthy expansion in the overall volume of credit, to excessive leverage, and to an unsustainable rise in asset prices, living beyond means, and speculative investment. Unwinding later on gives rise to a steep decline in asset prices, and to financial frangibility and debt crisis, particularly if there is overindulgence in short sales.

Chapra said the subprime mortgage crisis in the US was also the result of excessive and imprudent lending. “Securitization or the originate-to-distribute model of financing has played a crucial role in this. Mortgage originators collateralized the debt by mixing prime and subprime debt. By selling the collateralized debt obligations (CDOs), they passed the entire risk of default to the ultimate purchaser. They had, therefore, less incentive to undertake careful underwriting.”

Consequently a number of banks have either failed or have had to be bailed out or nationalized by governments in the US, the UK, Europe and a number of other countries.

“This has created uncertainty in the market and led to a credit crunch, which has made it hard for even healthy banks to find financing,” he said.

“When there is excessive and imprudent lending and lenders are not confident of repayment, there is an excessive urge for resorting to derivatives like CDSs to seek protection against default. The buyer of the swap (creditor) pays a premium to the seller (a hedge fund) for the compensation he will receive in case the debtor defaults,” he added.


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