Amidst the heat of one of the greatest fiscal meltdowns and the toxic assets, little niche practicians were considering whether this fiscal crisis has been averted the understanding Wall Street investing Bankss to implement the kernel of Islamic finance. Through empirical cognition and back uping groundss, we will look into the ‘rationale for Islamic Finance in the conventional economic environment ‘ in visible radiation of macro-/micro degree. Finally we will pull a decision.
Before we argue, from the Islamic finance protagonists ‘ position, on the annihilating catastrophe of interest-bearing merchandises, we need foremost to acquire a appreciation of how these financially engineered instruments afflicted this unprecedented harm to the macro-global economic system.
For the catchy phrases we heard during the crisis such as ‘U.S. sub-prime market ‘ or ‘toxic assets ‘ , they are all comparatively boil down to some of these opaque securities, which enables the conceiver of loans to reassign the hazard from its balance-sheet ( B/S ) to others, such as collateralized debt duties ( CDOs ) , residential mortgage-backed securities ( RMBS ) , recognition default barter ( CDS ) and structured investing vehicles ( SIVs ) .
Harmonizing to pre-crisis statistics, the value of the overall fanciful sums of OTC contracts reached $ 596 trillion by the terminal of 2007, with recognition default barters increasing by 36 % during the 2nd half of the twelvemonth to make $ 58 trillion ( BIS, 2008 ) . This is evident when one compares the size of the derived functions with the existent economic system. In 2007, the GDP of the US was $ 13.8 trillion ( and universe GDP was $ 54.3 trillion ) ( Ahmed, 2009 ) .
The traditional fiscal intermediation theoretical account, in which depositors provided financess to the Bankss for investing, was replaced by raising financess from the market through securitisation ( Ahmed, 2009 ) . Good and poor-quality mortgages were bundled together in securitized bundles and full default hazard sold to mediators ( Hassan and Kayed, 2009 ) . These mortgage-backed securities were sold to secondary investors and traded in the intermediary market.
In other words, the formation of toxic assets came to existence from the minute the mortgage loaners lend the sub-prime borrowers, while taking in head that the fiscal establishment does non anticipate them to refund. Here, fiscal technology comes into drama when the investing bank bundles up the ‘right ‘ to be repaid and sells it to institutional investors.
Based on Habib Ahmed ‘s ( 2010 ) presentation, there are figure of grounds of recent meltdown in the planetary economic system, which are follows in Table-1:
Driven by inordinate profit-motives, banks/ fiscal establishments engaged in sub-prime loaning ( with adjustable involvement rates ) ,
Loans packaged as Mortgage Backed Securities ( MBS ) / Collateralized Debt Obligations ( CDO )
55 % of the $ 10.2 trillion loans securitized ( stop 2006 )
12-15 % of securitized loans were sub-prime,
Rating Agencies gave positive rates to these securities ( to acquire more
concern and roll up fees ) ,
Investors ( Bankss, hedge and pension financess, municipalities, schools, etc. )
acquired these securities,
Investors/speculators bought Credit Default Swaps ( CDS ) to fudge recognition
National sums of OTC Derivatives in 2007 $ 596 trillion, CDS $ 58 trillion ( US GDP $ 13 trillion ) ,
Issuers of CDS ( Investments Bankss and Insurance companies ) took on the
hazard of default.
Table-1: Devising for the Crisis ( Source- Ahmed, 2010 )
At the clip when the market meltdown was at hand, investing houses were puting on what shortly to be called ‘toxic assets ‘ as one office was repackaging these mortgages by taking them from its B/S, while one section was countervailing the ‘risk transference ‘ by buying MBS or CDO. By the terminal of 2006 about 55 % of the estimated sum of $ 10.2 trillion value of mortgage loans in the US was packaged and sold to local and planetary investors ( Norges Bank, 2007 ) .
Every crisis has its ain trigger and for this one, it was the subprime borrowers. The clever mortgage bankers figured out an advanced manner to acquire financially strapped persons to measure up for a place loan utilizing slack underwriting criterions ( Ebrahim, 2009 ) This advanced manner was through the usage of “ detonating ” adjustable rate mortgages ( ARMs ) with remarkably low introductory ( i.e. , “ teaser ” ) rates, which reset to higher rates at the termination of the introductory 1s ( Ebrahim, 2009 ) .
Unfortunately, the payments increased drastically ( with the expiration of the teaser rate ) every bit good as plummeting place monetary values. As a consequence, borrowers were unable to refinance ( or sell ) their places, as their values were significantly below their mortgage balance ( go forthing them with negative equity ) ( Ebrahim, 2009 ) . One triping factor was the gradual addition in involvement rates from 1 % to 5.25 % between 2004 and 2006 ( Bianco, 2008 ) .
Given the lame fiscal base of the sub-prime clients, an addition in higher mortgage episodes led to default on payments. As sub-prime loans constituted 12-15 % of the securitised mortgages ( Norges Bank, 2007 ) , the plus base of the MBS and CDO started to gnaw with a loss in market value of more than $ 290 billion of bonds associated with sub-prime mortgages ; and it is estimated that more than 2.4 million American households have lost their places through foreclosures in 2007 ( Ebrahim, 2009 ) .
The influences of ‘interest rate ‘ in fiscal meltdown are visualizing in the undermentioned Table-2:
Interest rates began to lift ( 1 % to 2.25 % between 2004-2006 )
Adjustable rate sub-prime loans started to default
Holders of MBS/CDO incurred losingss
Monetary values of CDOs fell
Issuers of CDO had to pay the losingss caused by default
Losingss caused depletion of capital of FIs
Scramble to acquire financess
Money market froze ( as loaners did non cognize the hazards involve )
Lack of funding caused lodging market to crumple- farther decreasing
lodging ( CDO ) monetary values and increasing market hazards
Recognition hazards, market hazards, and liquidness hazards produced systemic hazards
Barbarous rhythm of de-leveraging and economic downswing.
Table-2: From Defaults to Economic Meltdown ( Source: Ahmed, 2010 )
From the micro-level, we will supply illustrations of debt-laden corporations and persons who became slaves of an involvement that was embedded in complex merchandises extremely non understood by the clients. In each illustration, we will hold the Islamic finance method of making concern.
While is Muslim finance does promote fiscal invention, it does, nevertheless, deter inordinate merchandise technology, notably the leveraged-related 1. For illustration, Centro Properties Group used a complicated and frequently opaque capital construction to turn into one of the universe ‘s largest and most-debt-laden shopping-centre proprietors ( Hudson, 2008 ) .
While conventional intermediation is mostly debt-based and allows for hazard transportation, Islamic intermediation, in contrast, is asset-based, and Centres on hazard sharing ( Hasan and Dridi, 2010 ) . In other universes, packaging debts through fiscal invention means hazard will be transfer to other counterparty to bear the hazard. Indeed, this type manner of funding can non shrivel the economic system by cut downing volume and figure of minutess ; since speculative and derivative minutess are by and large zero-sum games with a rare positive part to the economic system ( Chapra, 2009 ) .
Furthermore on the statement of derived functions, Gharar which is more likely expectable hazard that is embedded with these signifier of instruments which does non add value to the existent economic system. With bearing that in head, Islamic Bankss need to fudge against hazard. Therefore, other entities used fiscal technology to come up with stratagems/ artifices to besiege the prohibitions ( Ahmed, 2009 ) . For illustration, Al-Suwailem ( 2006 ) suggests utilizing a ‘cooperative technique of fudging currency hazards ‘ that does non use any derived functions. The undermentioned Table-3 is concentrating on some Islamic Financial Principles to avoid any fiscal convulsion ( such as, fiscal crisis-2007 ) :
Prohibition of merchandising of debt ( CDOs )
Prohibition on derived functions ( CDSs )
Prohibition on short-selling: – restricting wagering on downside hazards
Using risk-sharing instrument: – more monitoring
If Muslim rules were followed, the crisis would non hold taken topographic point the manner it did.
Table-3: Muslim Principles and Crisis ( Source: Ahmed, 2010 )
Driven by debt creative activity and direction fees, some family names were working their ill-informed corporate clients. For illustration, belongings proprietors at four Western luxury ski and golf resorts were be aftering to action Credit Suisse Group AG for $ 24 billion, impeaching the Swiss bank of running a “ predatory ” loan-to-own plan that loaded the resorts up with debt so it could prevent on their assets ( Palank, 2010 ) .
U.S. bankruptcy instance, said Credit Suisse devised a “ predatory ” loaning agreement that encouraged developers of several high-end resorts throughout the state to borrow big amounts without respect for their ability to refund ( Palank, 2010 ) . This statement of moral failure is echoed by the common position held by the bulk of Islamic fiscal bookmans and practicians are that the planetary fiscal crisis in world is a crisis of failed morality ( Siddiqi, 2009 ) .
By disregarding moral jeopardy, the US authorities had to bailout AIG, the universe ‘s largest marketer of CDS. But this came with heavy monetary value. Hank Greenberg, the former main executive of AIG, has accused the US authorities of botching the insurance company ‘s deliverance by enforcing a high-interest loan ( Guerrera and Freeland, 2009 ) .
What we can deduce from the above that the US Treasury exploited AIG fiscal distressed state of affairs by enforcing high involvement. Harmonizing to the Financial Times, Mr Greenberg criticised the involvement rate of 850 footing points over the LIBOR offered rate on the $ 85bn loan in the authorities ‘s first deliverance ( Guerrera and Freeland, 2009 ) .. “ If you think that is a manner to salvage a company, so we have a dissension, ” he said. “ That ‘s a manner to neutralize a company, non to salvage a company. ”
In the Islamic fiscal conventions, involvement can be viewed as the development of hapless debitors by loaners. Compound involvement makes the state of affairs worse. For case, the planetary fiscal crisis is taking a harrowing human toll in India ‘s metropoliss as some investors and stockbrokers, in desperation over losingss and debt, commit self-destruction ( Lamont, 2008 ) . With that in head, Toby Birch ( 2008 ) advocates that “ we owe it to the following coevals to liberate them from both authorities and mortgage debt. ”
In the Indian hapless households ‘ instance, offering Qard Hasan, which is an interest-free loan, would likely hold saved them from their fiscal wretchednesss. Indeed, merely as classical cognition was preserved by Islam during the pandemonium of the Dark Ages so Islamic Finance offers wisdom in modernness ; and it is the clip to do debt and involvement our common enemy, establishing a fresh fiscal order based on the penetrations of our ascendants ( Birch, 2008 ) .
Looking to the facts, it is true that Islamic fiscal establishments showed some resiliency to fiscal by executing much better than conventional Bankss. By this statement we mean that the nature of making concern by the Islamic finance manner was plenty to screen these establishments from the branchings of this crisis.
Apart from Islamic commercial banking, one besides must indicate out that in late 2009, the wholesale and investing banking sector in the Arab Gulf part went into fiscal distress state of affairs. But this is has nil to make with the interest-bearing merchandises, instead due to leading failure in hazard direction and variegation of grosss.
To sum up the lessons we can larn from the greatest meltdown after the Great Depression, the Islamic principals that helped the Islamic finance industry to debar, comparatively, the crisis are what follows ; These rules include the demand of ethical behavior in making concern ; the risk-sharing rule ; the handiness of recognition chiefly for the purchase of existent goods and services ; limitations on the sale of debt, short gross revenues, and inordinate uncertainness ; and the prohibition to sell assets non owned ( Hasan and Dridi, 2010 ) . The undermentioned Table-4 draws out the ethical and legal dimensions in visible radiation of both banking subjects:
Banks/financial establishments engaged in sub-prime loaning
Loans packaged as MBS/CDO
Rating Agencies gave positive evaluations to these securities
Investors/speculators bought securities
Creditss Default Swaps ( CDS ) to hedge/speculate on recognition hazards.
Risk-sharing manners are preferred and inordinate greed are discouraged
Selling of debt is prohibited
Dishonesty is discouraged
Derived functions are prohibited, due to guess is discouraged.
Table-4: Crisis and Islamic Finance: Ethical and Legal Dimensions ( Source: Ahmed, 2010 )
Possibly the most asked inquiry within the circle of Islamic bankers is whether Islamic finance is capable of re-creating such systematic hazard similar to what we have seen earlier. We believe that the Islamic finance industry is heading to a way of fiscal invention, coupled with some market-driven banking bookmans. The industry is more likely to hold an issue of credibleness in footings of the conformity of these banking merchandises with Shariah.
Now we are seeing the marks of “ ruddy flags ” which are coming from within the industry warning of similar episode of a crisis of some sort. In an effort to run into the demands of clients, the chief focal point of the Islamic fiscal industry became supplying ‘Shariah-compliant constructions for conventional merchandises ‘ ( Dar, 2007 ) . What we have here, is market-driven practicians who are acute to make hazardous and advanced niche Islamic merchandises.
At one extreme of this spectrum, the Islamic fiscal industry has been denounced as ‘deception ‘ and ‘charade ‘ ( Saleem, 2006 and El Gamal, 2007 ) claims Islamic fiscal establishments to be ‘rent-seeking Shari’a arbitrager ‘ utilizing ‘ruses to besiege prohibitions ‘ . Concerns are besides raised by the advocators of Islamic banking and finance. For illustration, Siddiqi ( 2007 ) maintains that the widely used instrument of tawarruq entails more injury ( mafasid ) than benefits and can non be characterized as Shariah-compliant.