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The role of Islamic finance in the post-crisis world
By Ahmad Muhammad Ali, president, Islamic Development Bank Group
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Excessive and imprudent lending was arguably the primary cause of the crisis that hit the global economy. Can Islamic finance help to restore market discipline?
The international financial system has just come out of a serious crisis that has been far more severe than any experienced in living memory. It took more than $3 trillion in bailouts and liquidity injections by a number of industrialised countries to abate the severity of the crisis. This action has intensified the call for a new architecture to minimise the frequency and severity of such crises in the future. Can Islamic finance respond successfully to this call?
It is not possible to answer this question without first determining the primary cause of this crisis. The most important cause of almost all crises is excessive and imprudent lending by banks. Market discipline should be able to prevent banks from resorting to the unhealthy practice of excessive and imprudent lending, which is not only against their own long-run interest, but is also a primary cause of international financial instability. But market discipline has itself weakened.
Discipline is enforced by incentives and deterrents. In the financial system, these take the form of risk and reward. Risks must be controlled effectively for this purpose. Profit-and-loss sharing can make a valuable contribution to realising this objective. If it is removed from, or weakened within, the financial system, the system will fail to operate effectively. Since banks are assured of a positive return on their advances in the conventional interest-oriented financial system, they have an incentive to lend excessively. The more they lend, the higher their profit. This phenomenon gets a further boost from recent innovations such as credit default swaps (CDS), which provide insurance to banks against loan losses. Collateralised debt obligations might be desirable if they were not an instrument for wagering. In addition, there is the ‘too big to fail’ concept, which assures big banks that governments’ central banks will come to the rescue.
The false sense of immunity from losses provided by these factors has contributed to a decline in market discipline, although such discipline is considered the pride of the market system. Banks do not evaluate loan applications carefully, which leads to an unhealthy expansion in the volume of credit and excessive leverage. The availability of excessive credit produces not only an unsustainable rise in asset prices and living beyond one’s means, but also increased speculative activity. Unwinding later on causes a steep decline in asset prices, as well as financial frangibility and debt crises, particularly if accompanied by overindulgence in short sales. As Jean-Claude Trichet, president of the European Central Bank, says, “A bubble is more likely to develop when investors can leverage their positions by investing borrowed funds.”
The recent sub-prime mortgage crisis in the United States is a classical example of excessive and imprudent lending. Securitisation or the originate-to-distribute model of financing played a crucial role. Collateralised debt obligations, which mixed prime and sub-prime debt, made it possible for mortgage originators to pass the entire risk of default to the ultimate purchasers who would have normally been reluctant to bear such risk. Mortgage originators did not, therefore, have adequate incentive to undertake careful scrutiny of the debt proposal. Consequently, loan volume gained greater priority over loan quality and the amount of lending to sub-prime borrowers, as well as speculation, increased steeply. ‘Teasing’ rates to attract unsophisticated borrowers boosted this phenomenon further. Ben Bernanke, chair of the US Federal Reserve System, observed that “far too much of the lending in recent years was neither responsible nor prudent. In addition, abusive, unfair or deceptive lending practices led some borrowers into mortgages that they would not have chosen knowingly.”
Market discipline thus fell short. Even the supervisors did not perform their task effectively by not nipping unfair practices in the bud. The result was that several banks either failed or had to be bailed out or nationalised by the governments in the United States, the United Kingdom, Europe and elsewhere. This created uncertainty about the recovery of loans and rendered banks reluctant to lend. The consequence was a credit crunch, making it hard for even healthy institutions to find financing. There was a lurking fear of a prolonged recession. The timely intervention by governments and central banks with enormous injections of liquidity averted this.
When there is excessive and imprudent lending and lenders are not confident of repayment, derivatives such as CDS are used excessively to protect against default. The buyer of the swap (creditor) pays a premium to the seller (a hedge fund) for compensation in case the debtor defaults. If this protection had been confined to the actual creditor, there might not have been any problem.
However, hedge funds sold the swaps not to just the actual lending bank but also to many others who were willing to bet on the default of the debtor. These swap holders, in turn, resold the swaps. The whole process continued several times. The Bank for International Settlements estimated that in 2007 the total outstanding derivatives (including $54.6 trillion in CDS) rose steeply to $600 trillion, more than ten times the size of the world economy. While a genuine insurance contract indemnifies only the insured party, in the case of CDS several swap holders had to be compensated. This greatly accentuated the risk and made it difficult for the hedge funds and banks to honour their commitments. No wonder George Soros described derivatives as “hydrogen bombs”, and Warren Buffett called them “financial weapons of mass destruction”.
One of the most important objectives of Islam is to realise greater justice in human society as stated in the Qur’an. Justice, however, requires a set of rules or moral values, which everyone accepts and faithfully complies with. The financial system may be able to promote justice if, in addition to being strong and stable, the financier also shares in the risk so as not to shift the entire burden of losses to the entrepreneur.
To fulfil this condition of justice, Islam requires both the financier and the entrepreneur to share the profit as well as the loss equitably. For this purpose, one of the basic principles of Islamic finance is ‘no risk, no gain’. This should motivate financial institutions to assess risks more carefully and to effectively monitor the use of funds by borrowers. The double assessment of risks by both the financier and the entrepreneur should help inject greater discipline into the system and go far in reducing excessive lending.
Islamic finance should, in its ideal form, raise substantially the share of equity and profit-and-loss sharing in businesses. Greater reliance on equity financing has supporters even in mainstream economics. Henry Simons of the University of Chicago, writing after the Second World War, argued that the danger of economic instability would be minimised if there were no resort to borrowing, particularly short-term borrowing, and if all investments were held in the form of equity. More recently, Harvard University’s Kenneth Rogoff has said that in an ideal world, equity lending and direct investment would play a much bigger role.
Greater reliance on equity does not necessarily rule out debt financing. This is because the financial needs of individuals, firms or governments cannot all be amenable to equity and profit-and-loss sharing. Debt is, therefore, indispensable, but should not be promoted for non-essential and wasteful consumption and unproductive speculation. For this purpose, the Islamic financial system does not allow the creation of debt through direct lending and borrowing. It requires the creation of debt through the sale or lease of real assets by means of its sales- and lease-based modes of financing (murabahah, ijarah, salam, istisna and sukuk). It has, however, laid down a number of conditions for the effective operation of these modes.
The first condition is that an asset being sold or leased must be real, and neither imaginary or notional. Second, the seller or lessor must own and possess the goods being sold or leased. Third, the transaction must be a genuine trade transaction with full intention of giving and taking delivery. Fourth, the debt cannot be sold and the associated risk must be borne by the lender.
That first condition helps eliminate many derivatives transactions that involve nothing more than gambling by third parties that claim compensation for losses suffered only by the principal party. The second condition ensures that the seller (or lessor) also shares the risk in order to get a share in the return. The seller (financier), on acquiring ownership and possession of the goods for sale or lease, bears the risk. This condition also constrains short sales, thereby removing the possibility of a steep decline in asset prices during a downturn. Shari’ah law has, however, made an exception to this rule in the case of salam and istisna, where the goods are not already available in the market and must be produced before delivery. Financing extended through Islamic modes can thus expand only in step with growth in the real economy and thereby helps curb excessive credit expansion.
The third and the fourth conditions not only motivate the creditor to be more cautious in evaluating the credit risk but also prevent an unnecessary explosion in the volume and value of transactions. This limits debt from exceeding the size of the real economy and releases substantial financial resources into the real sector, thereby increasing employment and self-employment and producing need-fulfilling goods and services. The discipline that Islam introduces in the financial system may not, however, materialise unless governments reduce their borrowing from the central banks to a level that is in harmony with the goal of price and financial stability.
Thus the Islamic financial system is capable of playing a stabilising role in the global economy by eliminating the major weaknesses of the conventional system and thereby helping minimise the severity and frequency of financial crises. By requiring the financier to share in the risk, it introduces greater discipline into the system. It links credit expansion to the growth of the real economy by allowing credit primarily for the purchase of real goods and services that the seller owns and possesses and the buyer wants. It also requires the creditor to bear the risk of default by prohibiting the sale of debt, thus ensuring a more careful evaluation of risk.
Islamic finance has been growing rapidly in recent decades. But it is still in its infancy and holds only a very small proportion of international finance. It has far to go before it attains maturity and starts reflecting the ethos of Islamic teachings. The use of equity and profit-and-loss sharing remains relatively small, while debt-creating modes remain preponderant. This is due in part to inadequate understanding of the ultimate objectives of Islamic finance, the non-availability of trained personnel and the absence of a number of shared or support institutions needed to reduce risks associated with anonymity, moral hazard, principal/agent conflict of interest and the late settlement of financial obligations. However, the system will gradually gain momentum and will effectively complement the current international efforts to bring health and stability to the global financial system.
The Islamic financial system is not something unique and unknown to the world of finance. It only represents an effort to revive some of the universally accepted principles of sound and healthy finance that have, in fact, been a part of the conventional system, but have gradually become weakened over the last few decades. This weakening has given momentum to the crises. Therefore, for the future health and stability of the global financial system, it is desirable for the conventional system to adopt the sound principles of its own heritage, which the Islamic financial system is trying to revive.
Such principles of Islamic finance include the following: The proportion of equity in total financing must be increased to create a proper balance between equity and debt. Credit must be confined primarily to transactions related to the real sector to ensure that credit expansion moves in step with the growth of the real economy and does not promote destabilising speculation and gambling. Leverage must be controlled so that credit does not exceed the borrower’s ability to repay.
Furthermore, if it is not desired to prevent the sale of debt in keeping with Islamic teachings, there should be full transparency about the quality of debt being sold so that the purchaser clearly understands the ramifications of the transaction. The ultimate purchaser of the debt should have the right of recourse, which would ensure that the lender has an incentive to underwrite the debt carefully.
Moreover, while there may be no harm in the use of CDS to protect the lender against default, they must be insured so as not to become instruments for wagering. Their protective role should be confined to the original lender and not cover the other purchasers of swaps who wish to wager on the debtor’s default. For this purpose the derivatives market must be properly regulated to remove the element of gambling.
The compensation of bank management must be rationalised to safeguard against the taking of unnecessary risks. This rationalisation should, however, not deprive them of their due reward for their contribution to efficient and prudent management.
Finally, all financial institutions, and not just the commercial banks, must be properly regulated and supervised so that they remain healthy and do not become a source of systemic risk.
The adoption of these principles should put the international financial system on a sound footing and thus minimise the frequency and severity of crises. Nonetheless, prudent regulation and supervision remain important, and should continue to complement the greater discipline that must be injected into the system.
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