Islamic Financial Perspective to Overcome Financial Crisis Keywords

IslamicFinancial Perspective to Overcome Financial Crisis

[StudentName’s]

Keywords

GlobalFinancial Crisis GFC-the world wide crisis that peaked in 2008-2009 period, affectingmainly the US, European and certain Asian countries, but feltthroughout the world

CollateralizedDebt Obligation CDO-A financial product popular before the GFC in which several loanswere bundled and investors sort to finance them

CreditDefault Swap CDS-A financial tool in which risk of default of CDO was sold for apremium to investors who were paid when CDOs were defaulted

IslamicFinance-The principles that govern Islamic finance and trade includingbanking, insurance, retail trade and government regulations

Leverage-The ratio of a company’s debt financed operations to its own assets

FullReserve Banking-a banking model that requires that banks must retain all thedepositors’ funds and not utilize them in investments and loans

FractionalReserve Banking-model that requires banks to retain a certain percentage of depositsand use the rest

ShariahBanking-Banking that is in line with the Islamic teachings and regulationsunder the Quran

Abstract

Islamicfinance is an emerging concept in credit markets that is a promisingnew concept of avoiding crises. This paper is dedicated towardsapplying Islamic banking and credit principles in order to fightglobal financial crises. The Islamic principles governing trade andcommerce are well laid out under Shariah law. They extend the fullrange from governments, companies and businesses to individuals andto demonstrate the efficiency of these principles, theirapplicability in the global financial crisis of 2008_2009.

Contents

Executive Summary 6

1.0 Chapter 1: Introduction 9

1.1 Research Problem 9

1.2 Research Objective 9

1.3 Research Scope 9

1.4 Research Questions 10

2.0 Chapter 2: Literature review 10

2.1 Background of Financial Crises and Islamic Financial Regulations 10

2.1.1 Financial Crises 10

2.1.2 Banking Crisis 11

2.3 Islamic financing perspective on Bank Crises 14

2.4 Speculation bubbles and market crashes 15

2.5 Islamic perspective 16

2.6 International financial crises 18

2.7 Wider economic crises 20

2.8 Causes of financial crises 21

2.8.1 Lack of regulation 21

2.8.2 Leverage 23

2.8.3 Market panics, uncertainty and complementary strategies 24

2.9 Islamic Financial Principles 26

2.9.1 Mudarabah 27

2.9.2 Murabahah 28

2.9.3 Musawamah 29

2.9.4 Bai Salam 31

2.9.5 Musharaka al Mutanaqisa 31

2.9.6 Gambling (Bayu al- gharah) 32

3.0 Chapter 3: Methodology 34

3.1 Global financial crisis 34

3.1.1The US Housing Bubble 34

3.2 Background 39

3.2.2 Expansion of the housing bubble 44

3.2.5 Deregulation 46

3.2.6 Over-leveraging 46

3.2.7 Financial innovations 47

3.2.8 Incorrect pricing of risk 47

3.2.9 Rise and fall of the shadow banking system 48

3.3 Rise of commodities 48

3.4 Systemic crisis 49

3.5 Impact on financial markets 49

3.6 U.S. Stock market 49

3.7 Financial institutions 50

3.8 Credit markets and Shadow banking system 50

3.9 The Islamic World and the financial crisis 51

4.0 Chapter 4: Analysis of findings 51

4.1 Islamic Financing Solutions to Financial Crises 52

4.2 Solutions to the Stock Market 52

5.0 Chapter 5: Conclusion 61

References 62

AnIslamic Perspective to Financial Crises

ExecutiveSummary

Inyear 2009, major US financial services institutions nearly collapsed.Major economies’ governments engaged in massive bailout programsfor major financial institutions to avoid possible total collapse.Some of the leading global companies in western economies such asLehmann Brothers, Meryl Lynch, American Insurance Group (AIG), anddozens of real estate investment companies filed for bankruptcy(Simkovic, 2009). This wave of rapid devaluation of major investmentcompanies was spread throughout the universe, with similarramifications felt in major European economies and elsewhere in theworld. The estimated total losses due to this credit depletion was inexcess of $1 trillion, with the bulk of the losses being met bygovernments from taxpayers money, as well as direct investment lossesfor millions of investors (Justin, 2007). No Islamic bank ormainstream institution was significantly directly affected in the2008-2009 crisis, as interest driven speculative lending isprohibited under Shariah Law (Justin, 2007).

Insteadof retaining the proactive control system that regulated thefinancial services sectors in most countries at the turn of the 20thcentury, most countries have slacked their control over credit risk,borrowing and lending regulations, as well as capitalisticmonopolization in the investment market. As a result, most financialbubbles grow to maturity driven by the market economy, which leads tolosses that are investigated by commissions of inquiry, and whosereports lead to more financial Acts of Parliament. Islamicregulations on financing, banking and related investment marketshave, however, stood firm to control the risks associated withcapitalistic extremes, as well as to ensure fair and equitabledistribution of wealth in an economy (Simkovic, 2009). This paperwill focus mainly on the contributing causes of major financialcrises with a special focus on the Global Financial Crisis of2007-2009 as a recent and highly impactful event, and also on howsound Islamic financing regulations might have prevented it, as wellas accelerated recovery from it, had they been adopted. To illustrateIslamic regulations, case examples of countries and jurisdictions inwhich such systems are in force will be introduced.

Listof Figures

Figure1: TED Spread between 2008-2009 page 35

Figure2: Subprime lending and home ownership in the US between 1990-2006page 37

  1. Chapter 1: Introduction

The2008-09 global financial crises presented a challenge that hasconstantly been in the research priorities all over the world aseconomists and scholars try to find a solution to future occurrences(Justin, 2007). The aim is to prevent any future crisis. Oneoutstanding realization in the last crisis is that Islamic economieswere not as hard hit as other economies, and even then they were onlyindirectly affected due to overreliance on oil trade, a commoditywhose exchange base currency is still largely the dollar and whosemain markets are still western countries and China. However, noextensive research has been made to discover the reasons why Islamicnations’ credit markets remained intact, and whether the principlesthey employ are viable on a wide scale to prevent crises. This paperwill explore the world of Islamic finance with a view to find outapplicability of its concepts to prevent crises.

    1. Research Problem

Theresearch problem is evaluating the operational efficiency of Islamicfinance principles in fighting global financial crises. The widerproblem in the scope of the research is preventing financial crises.

    1. Research Objective

Theobjective of the research is to show whether Islamic financeprinciples could have prevented the global financial crisis of2008-2009.

    1. Research Scope

Thescope of the research is the entire world’s economy butspecifically the US as the origin or the crisis as well as the worsthit country. The Islamic finance principles are applicable worldwide.

    1. Research Questions
  1. What are the reasons why crises arise and which particular reasons led to the global financial crisis?

  2. What are the basic Islamic finance principles?

  3. Would these principles have helped prevent the crisis?

  4. What future practices should the economic sectors use to avoid crises?

2.0Chapter 2: Literature review2.1Background of Financial Crises and Islamic Financial Regulations2.1.1Financial Crises

Throughthe history of humans, business has been conducted with the aim ofrealizing profitability and growth. The most basic forms of tradehave existed over millennia to enable people obtain what they neededand dispose of what they did not. Original trade was shaped by theforces of demand and supply in its basic form, and thus thrived wellthousands of years. In the wake of organized society, a centralmedium of exchange was introduced to enable a harmonious manner ofcomparison of value between traders (Justin, 2007). In addition tointroduction of money, the system of taxation and market regulationwas founded. The market based financial system continued to thrivedriven by demand and supply forces. The issue of resource depletionand scarcity was a driving force for the competition, andconsequently government intervention in terms of trade laws. In linewith this, some markets emerged as capitalist, while others favored acommunist system. Capitalists encouraged the amalgamation of wealththrough legally acceptable channels, while communist systems favoreda more centrally regulated wealth policy (Simkovic, 2009).

Afinancial crisis is what results when the self driven balance ofdemand and supply is threatened through value degradation, shortageof either demand or supply, or collapse of the underlying marketforces driving trade. While all these factors may contribute to acrisis, the underlying cause of any crisis is value degradation in adominant market item (Gordon, 2008). To control markets and avoidcrises, governments have over time defined conditions to be used.Different control methods are applicable for different types ofcrisis. Financial crisis can be classified either as banking crisis,speculative asset bubbles and crashes, international crisis, or widereconomic crisis. The methods used to regulate each type may vary, butusually more than one type of cause is involved. In the 2007-2008crises, for instance, the US housing bubble was the original cause ofthe chain of events. This bubble was further aggravated by theavailability of cheap credit which local financial institutions werepushing to anyone willing to own a home, a credit bubble thusresulted (Simkovic, 2009). Lack of proper credit securitizationpeaked in 2008, and when everyone realized that the asset scheme wasunsustainable, the home ownership proxy which was at the middle ofthe entire credit scam swiftly lost its appeal, leading to massivedevaluation of assets. This led to several banking crises withinmajor countries, which affected the economic sector globally- thuscausing an international crisis. The section below will explore thenature of each of the crisis (Gordon, 2008).

2.1.2Banking Crisis

Bankingcrisis arise when depositors overwhelmingly decide to withdraw theirdeposits from banks. Such massive withdrawals or bank runs are causedby investor or depositor panic caused by various factors such asdeclining economic performance, mismanagement of banks, or otherunfavorable outcomes. Traditionally, banks use depositors’ money todo their mainstream business, mainly in lending to willing people(Gordon, 2008). Therefore, in the event of a bank run, most bankswould not be able to pay off all depositors on demand, and wouldtherefore be declared bankrupt. Major banking systems have operatedusing a fraction-based reserve banking, where a certain percentage ofall deposits must be retained for emergency and cash based operations(Simkovic, 2009).

Historically,bank runs have occurred in numerous instances and for differentreasons. As early as the 16thcentury, banks in the US and Canada were experiencing bank runs as aresult of depositor panics. In the time, there were poor governmentregulations in the US on private banks, and many succumbed toinsolvency when economic conditions were unfavorable. The MontrealCity crisis was one of the early popular instances in Canada (Diya,2008). The US also experienced similar experiences in the bankingsector. The great depression for instance, had multiple bank runsthat happened in 1929 to 1933, when investors massively withdrewtheir deposits from American private banks (Gordon, 2008). Thefractional reserve banking, which is a model that banks only retain acertain percentage of investors’ funds in reserves but invest therest in loans and securities are the system currently in use in mostcountries. This implies that banks may invest depositors’ funds toalmost 100%, thus leaving them vulnerable to insolvency in the eventof a small depreciation in asset value. In the crisis of 2009, somecompanies had attained leverage levels (or the ratio of debt toassets) of 33, meaning a mere asset depreciation of 3% would havedeclared the banks insolvent.

Historically,governments have intervened to ensure that, while the percentage ofdeposits that banks could use in investments was regulated by thebanks, the nature of the investments a bank could get involved inusing depositor funds were strictly regulated. This ensured that inthe event of disbandment of a bank, the bulk of investor funds couldbe retrieved through sale of bank assets or other instruments. The USalready had a strong regulation of this kind, through several Acts ofParliament enacted early in the 20thcentury (Gordon, 2008), that prohibit speculative investment ofdepositors money. Most of these rules were repealed over the century,giving banks more control over their investments. In contrast Islamicbanking law prohibits interest based lending, in line with the Quran(Gordon, 2008). This essentially eliminates the greed for instantprofit, an issue that is almost always a contributing factor inbanking and other financial services malpractices. In the 2007crisis, for instance, investment banks teamed with rating agencies tocome up with abstract financial instruments called CollateralizedDebt Obligations (CDOs) and Credit Default Swaps (CDS), thatpurported to spread risk in an investment market, while in the realsense these products heaped the risk on unsuspecting investors and afew insurance companies that insured them (Gordon, 2008).

Governmentagencies that were supposed to control the spread of these toxiccommodities could not do so because they were indirectly linked tothe profiting side of the scams. In Islamic banking, the majorincentive is to avail finance to the market sector in an economythrough controlled policies that discourage the idea of profit as theprimary driver of banking services. With high risk-high profitbanking incentives removed, it would be easier to monitor and controlbank lending using Islamic financial policies, and thus avoid bankruns and the resulting crises (Diya, 2008).

2.3Islamic financing perspective on Bank Crises

Islamicfinancing especially through banks is essentially very different fromthe conventional banking system. The ideal banking regulations forIslamic banks are that they should maintain

2.3.1Full Reserve Banking

Thisconcept requires that a bank must reserve the total sum ofdepositors’ funds. This means that in the event of a bank run, thebank would be able to settle all depositors’ accounts and avoidinsolvency. Full reserve banking is impractical in the conventionalbanking system because banks make their profits mainly from lendingout depositors money to investors. However, banks may also engage ininvestment of funds obtained in ways other than deposits, such asthrough floatation of IPOs to enable the public to invest in them, orthrough profit reinvestment, or through capital injection by bankowners. Islamic banks operate under obligations to ensure almost fullreserve banking.

However,even for Islamic banks, it is impossible to maintain full reservebanking as these banks also offer financing to clients (Diya, 2008).For these, however, the form of finance commitment is such that nodirect lending can occur as Shariah law prohibits direct interestlending. Instead, these banks establish arrangements with theirborrowers, most of whom are customers, to either enter into jointventures with the banks where the bank can provide capital and thecustomer or borrower provides expertise (Mudharabah), or throughleasing (ijah), or any other of the several methods permitted inwhich the bank can offer funds to customer for the benefit of bothparties. Thus, the Islamic concept largely avoids bank runs or othercrises through inclusion of the majority of lenders into forms orpartnership or other joint finance arrangements through which boththe bank and the client share the profits or losses arising from thefinancing transaction (Askari, 2010).

2.4Speculation bubbles and market crashes

Speculationbubbles result when short term investors put their resources on acommodity they consider to be quickly appreciating in value, ordeclining in supply, in such a manner as to help them realize highprofit levels within the short term of investment. As an example, thefinancial crisis of 2007-2009 started with the American Housing Boom,a wave of financed investment in home buying. The speculation startedin mid 2005, while the housing scheme itself had already been inplace as early as 2002 (Askari, 2010). Home owners who had accessedthe finance to buy their homes realized that they could actually selltheir homes for much more than they cost, and could therefore payofftheir home loans and keep a profit. The loaning banks on the otherhand were advancing aggressive campaigns in homes, offices and otherworkplaces to get people to take the loans. This compound phenomenonmanifest as an opportunity for people without any real securitizationto access bank funds to buy homes that they could immediately selland keep a descent profit, an offer they could not refuse.

Thedriving force behind the massive campaign for loans was the need bylending firms to make huge profits, and therefore pay themselves hugebonuses for exceeding sales targets, a practice that is widespread intoday’s corporate world. Again, in Islamic finance, the practice oflending for an interest is prohibited, and the events of the lendinginstitutions would not have been allowed (Askari, 2010).

2.5Islamic perspective

InIslamic finance, it is illegal to engage in speculative lending orborrowing where the only or main aim is to get a profit. Clearly,financers of the housing scheme in the 2002-2007 pre-crisis had noinvolvement in the post-crisis outcomes for the people they lent themoney to. In any case, the financing institutions gained huge profitsimmediately the deals were made, and were not in any way heldresponsible for the long term effects of their speculative lending inthe post crisis public enquiries (Berlatsky, 2010). Instead, millionsof small investors, as well as several major insurance and investmentcompanies, were forced to absorb the losses. In Islamic financing,lending of the nature engaged in by these banks would havenecessitated that the banks get their profits from the marketperformance of the loans (Musharaka), and would therefore havediscouraged the financers from financing operations they consideredrisky or illegal, as this would have implied that in the event of anegative outcome the banks too would have equally borne the losses.There is evidence in the post crisis enquiries, especially thoseinvolving Leyman Brothers Company officials’ chain of e-mails, tosuggest that the investment banks had a clear insight into theimminent collapse of the financial bubble and speculative trading intoxic assets (Kates, 2010).

Bydefault, an asset may have a speculative price much different andoften exploded, than its intrinsic value. This is a typical componentof assets in a speculative market setting. In naturally growingmarket practice, an investor or buyer purchases a commodity expectingit to retain its intrinsic value and grow organically subject to lawsof appreciation and inflation. In a speculative market, an investorbuys goods under the motivation of market speculation in which theyexpect the price to hike rapidly and give them a high margin ofprofit within a short time. Speculation thrives well to create abubble, which is a period of exaggerated property or asset valueswithin a market setting, so as to greatly deviate from theirintrinsic value. While it is expected that the objective of anybusiness to make profit, and that profit implies a difference betweenpurchase price and selling price where purchase is assumed to precedesale, Islamic discipline would prohibit unfair advantage by a sellerin a trade transaction (haraam). Islamic principles prohibitextortive business, as in the case of financial lending where thelender has knowledge that the buyer maybe cheated during thetransaction (Kates, 2010).

Asnoted by Kates (2010), market crashes are phenomena where after acommodity pile up due to speculative buyers in a market, suddenlythere are not enough willing buyers to take up the commodity, andtherefore the commodity price dramatically falls. This phenomenon ismost evident and dramatic in markets handling perishable or timebound goods, where the failure by sellers to dispose of them mayimply serious losses within a short timeframe. Typically in marketcrashes, it is the investors who bare the losses as buyers areunable or unwilling to sustain the demand- supply balance, and priceshave to significantly come down to retain the demand- supplyequilibrium (Sun, Stewart &amp Pollard, 2011). A perfect example inthe global financial crisis was the rapid rise in foreclosure ofhouses issued in the housing bubble. Typically, any bubble must cometo a crash in its course unless there is a steady supply of financialresources in the system to fuel it, a scenario which is impracticalas a true market system will always have a finite value at any time,the growth of which must be due to intrinsic value creation. Islamicprinciples do not prohibit making profits through lawful means, butthe government or other regulatory bodies are mandated in controllingpractices that may endanger the natural process of wealth creationand distribution in a market setting. This is the underlyingprinciple of Islamic finance. In the financial markets history,market crashes have happened for several hundred years.

In1873, the Vienna Stock Exchange, suffering major price inflation ofcommodities, came under imminent crash, leading to the famous Panicof 1873, an event that caused a major depreciation in stock prices,and a lengthy depression in the following years (Sun, Stewart &ampPollard, 2011). In a crash, the most immediate outcome is losses byinvestors holding the affected commodities. In the long term, theprices may still recover, but the damage caused by the time delay isirrecoverable (Sun, Stewart &amp Pollard, 2011).

2.6International financial crises

Theobject of international financial crises is usually in the object ofinternational finance. The global economy is driven by currencyexchange rates. Thus, economies that control the majority of thecurrency used for international transactions have an advantage inthat their specific economic performance is not important inretaining the value of their currency (Sun, Stewart &amp Pollard,2011). Instead, the value is determined by the performance of allother economies that use its currency to performance exchanges intrade. As an example, the US Dollar has dominated the internationaltrade exchanges since the end of World War II to the time of the riseof the European Union and formation of the Euro. Thus, the economy ofthe US was largely aided by its regulations of the internationalmarket through its currency as a medium of exchange. Thus, a simpledepreciation in the value of the US Dollar has always had compoundeffects on all international markets whose performance is based onthe Dollar exchange rates. One such example is the adoption of theDollar for the petroleum trade exchanges for more than half a centurysince the 1950s. This phenomenon was so marked that in the energyindustry there was the conceptualization of the petrodollar(Venardos, 2010).

Foras long as the dollar remained the base currency in the oil trade,the specific performance of all countries who were producing andexporting oil was pegged on the stability of the dollar, which wasregulated by the US policies. If the US economy crashed, along withit the global economy would get affected. A similar effect can besaid of the dominion of the Euro in the European countries where, theEuro is the major currency. However, the EU case is one of consensualmembership, the countries under the EU can only benefit from thesuperiority of the EU, but non EU members will always have theircurrency values adjusted in accordance to that of the Euro. This hasbeen the scenario with the majority of the Islam nations, especiallyoil producing Islamic countries. The instability that rocked the USfinancial markets and the dollar as a result of the collapse of thehousing bubble and the associated toxic financial derivatives spreadproportionately to other countries Europe, Asia and elsewhere. MajorBritish banks and other companies were greatly affected in thecrisis, with dollar exchange rates reaching highs not experienced inmany countries for several decades. The particular bubble that couldbe considered as the driver of the international market crash in2008-2009 is that of the financial commodities formulated andpopularized in the last decade, namely Collateralized DebtObligations (CDOs) and Credit Default Swaps (CDSs), which were tradeddirectly in the US and UK markets as well as highly in theinternational markets. These toxic products will be discussed indetail in a later section (Venardos, 2010).

Traditionally,balance of payments crises arise in cases of devaluation on acountry’s currency in a fixed exchange setting. Exchange rates, inturn, are an inevitable property of international trade. Thus, for aslong as exchange rates are unfavorable, internal crises are bound tooccur. To illustrate the scenario in the global financial crisis thatdemonstrates how an international crisis may arise, this paper willuse the case of the US deficit in balance of payments. Between 1996and 2004, the US had accumulated a huge 5.8% deficit in its balanceof payments identity, which means that its current account deficitwas higher than its capital account by the amount of $650 billion.The then treasurer of the Federal Reserve Ben Bernanke authorizedforeign borrowing by the government to supplement this deficit. Theresult was an influx of foreign capital in the US economy, most of itfrom countries that had a trade surplus, as well as from investors inoverseas countries (Venardos, 2010). The majority of foreigninvesting countries did so through treasury bonds, which safeguardedtheir interests against currency devaluation. The majority of privateinvestors including foreign investment banks, however, did so throughdirect currency injection into the US financial markets. Theseinvestments were channeled into the housing scheme and consequentlylost in the crisis. Thus, the larger percentage of the $ 1 trillionthat was lost in the scheme was actually owned by foreign investors,and this constituted an international crisis (Kates, 2010).

Creditcrises have occurred in many countries. The 1998 financial crisis inRussia led to currency devaluation and default in government bonds.Asian capital markets faced crisis in 1997, and the Europeancountries faced a crisis in 1992-1993. No major crises of this naturehave happen in any major Muslim economy, partly because Islamicnations exercise careful monetary control and fiscal policies, aswell as because there has not been many major economic ties betweenthe Islamic world and the western economies due to conflictingfinancial policies (Berlatsky, 2010).

2.7Wider economic crises

Thesecrises may not be caused by any specific action or omission in thefinancial markets, but maybe the result of numerous smaller factors.Wider economic crises are usually marked by negative GDP growth inmore than two quarters of a financial year. They may happen inisolation or may engulf several countries. When they happen inisolation, they usually are a result of fluctuations in a country’sinternal environment, such as inflation, political instability, andadverse natural occurrences among other factors. The wider crisisinvolving entire blocks of trade partners, continents or the wholeworld usually happen as combined events involving one or severalother types of crises. These crises are typical in every country ornation, and may not be an indication of any serious policy failureunless prolonged into a depression (Berlatsky, 2010).

2.8Causes of financial crises

Financialcrises have multiple, diverse causes. One underlying characteristicfor them all is that there is a period of exaggerated marketperformance which then reverses due to the failure of one or moreequilibrium factors. This section may not discuss all the possiblecauses of crises, but will discuss some of the major ones. It isimportant to note that while the general discussion will target abroad range, specific attention will be paid to those factors thatmay have contributed to the global financial crisis in 2008, as thisis the operational reference for this paper (Berlatsky, 2010).

2.8.1Lack of regulation

Nocrisis is without enough warning symptoms. Financial analysts andpolicy implementers almost always can predict with dependableaccuracy when a market system is headed for a crash. Governments arethe ultimate institutions that are mandated with regulation andcontrol of markets and economic outcomes that may lead to a crash orrecession. Left to itself in its natural state any system will tendtowards equilibrium where demand and supply ultimately drive amarket. Unfortunately, state control and other laws exist that areaimed at ensuring that multiple players in a market setting get fairopportunity, and these rules can often be manipulated by certainplayers to get undue advantage. Thus, the state must not only setrules for fair play, but enforce them continually and set systems todetect existing and emerging challenges that might affect theiraccuracy and efficiency. When governments fail to do this, thereexist lee-ways for certain market players to abuse the system(Askari, 2010).

Onemethod commonly used by governments to regulate the financial sectoris through regular reporting of financial statements and otherindicators of performance. Banks, for instance are supposed to retaina certain amount of funds as reserves to meet contingencies. Whenthis regulation fails, banks may invest far more than they areallowed to, making it riskier to manage internal crisis when itoccurs. In addition, the amount of paper money circulating in asystem must be regulated to manage inflation, as well as manage thelikelihood that a bubble maybe created by property price escalationowing to presence of huge amounts of paper money. Definite examplesof failure of governments to manage financial markets and the waythat led to the global crisis will be discussed in the next chapter.Regulations exist on various aspects of running a company, includingon capital requirements, leverage, and investment options (Askari,2010).

Regulation,however, have possibly disastrous consequences if so tightly applied.One such example is when the central banks order commercial andinvestment banks in a market to withhold lending in order to controlinflation at a moment when capital is critical for investment withinan economy. The result would be a rapid decline in purchase power,low average earnings, and thus possibly a crisis due to declineddemand. Such a backlash can be foreseen and managed with properregulatory provisions in a market system. Regulation therefore is adelicate balance between extremes, and must be accurately managed inorder to avoid crises (Askari, 2010).

2.8.2Leverage

Theconcept has been defined in different methods by different scholars.However, the fundamental ingredient of leverage is access to fundsbesides a company’s assets to use as capital or the benefit of theuse of borrowed money to run a business. In one definition, leverageimplies the ratio between a company’s total debts to its assets.When leverage is high, the company’s ability to manage a recessionor asset depreciation is thoroughly reduced. Where such scenariooccurs in many companies within a sector, a systemic risk results,which may quickly escalate into a crisis. In the global financialcrisis for instance, reports of leverage levels as high as 33 werecommon. This implied that a mere 3% depreciation in asset valueswould make the companies insolvent (Askari, 2010).

Bear-Stearns, a US mortgage company that was performing well in thepre-crisis years and was one of the leading mortgage financecompanies, was taken under in 2008 by an inability to renew a debt ithad incurred in a short term to finance mortgage securities of a longterm nature. Other banks in different regions, from Iceland toEurope, suffered the same insolvency problems owing to high ratios ofborrowed capital to own capital. As will be shown in later chapters,Islamic banks retain some of the lowest leverage values, with mostexercising full-reserve banking strategies in line with Shariacompliance that forbids the transfer of debt from one debtor toanother, or simply borrowing in order to pay another existing debtor(Venardos, 2010).

2.8.3Market panics, uncertainty and complementary strategies

Thisis the most unpredictable cause of crises. A market panic resultswhen people, mostly speculators, discern that a market commodity mayget into shortage, or that the demand for it may fail for aconsiderable amount of time. This panic may determine the decline orrise in investment in a certain commodity. Market panics usually arepsychological, without any real basis for occurrence. However, thepanic in itself often starts the very scenario that is dreaded, andproceeds to fulfill it as psychological fear makes investors follow aherd behavior. One example of the effect of a market panic orpsychological behavior is the Dot Com bubble at the turn of themillennium. At the time, the use of personal computers had reached anunprecedented peak since the commercialization of the PC in 1980s,and a programming oversight threatened to put entire informationsystems out of operation at the turn of the century. Investors,fearing the occurrence of the systems failure, opted out from buyingshares associated with companies based on IT and other companies evenremotely associated with internet technology. This caused a marketcrisis called the Dot Com bubble (Venardos, 2010).

Herdbehavior as a cause of crisis has been suggested by various scholarsand researchers as the tendency of investors to expect that anongoing market property will continue indefinitely or at least forthe duration in which it is of interest to them, and therefore act ina similar manner. For instance, speculators in a stock market mayforesee a rise in price of a particular stock and unanimouslypurchase the stock with a view to trade it just before the pricespeak. This herd behavior is also psychological, and extends to othereconomic sectors. This tendency to engage in practices are timelessand result in more losses than profit, yet investors always look atthe positive outcome, though it is evident that the negative outcomeis statistically and logically more likely. Thus, in the event of acrisis, the investment group that faces the largest loss is the lessexperienced speculators who exhibit blind optimism in marketperformance when they enter into the investment. One leading scholar,Charles Kindleberger, also explored crises situations and theorizedthat most crises always follow shortly after major technologicalinnovations. This trend Charles attributed to a displacement ofexpectations, a scenario he said is caused by a rational butexaggerated expectation by investors that the emergence of a newtechnology will completely phase out the older one, thus massivelypulling out of the market in expectation to invest in the newertechnology companies. Some of the popular crises that followed thisprediction include the Crisis of 1929, the Dot Com bubble of 2001,and the South Sea Bubble of 1720. The concept of strategiccomplementarity is similar to psychological herd behavior butinvolving the reaction of investors to the expectations they haveregarding their peers. In theory, a good investor is one who is ableto predict what other investors will do faced with a market scenario,and act accordingly with the aim of surviving competition at theleast, or beating competition (Venardos, 2010).

2.9Islamic Financial Principles

Thescope of Islamic financial principles is diverse and reaches intoevery single type of transaction involving companies, governmentcorporations, and individuals. For the purpose of this paper, thetypes of interactions that will prominently be studied include thosebetween governments to governments, corporations –corporations,companies to companies, and companies to individuals. In particular,the obligations of a government in controlling the financial sectorwill be discussed, as will be the obligations of lending institutionstowards their customers. These two types of interactions were thegreatest determinants of the pre-crisis global economic performancecharacteristics, and should accept the biggest blame for the globalcrisis. The section below will discuss the fundamental principles ofIslamic banking.

Islamicbanking is also called Sharia Compliant Finance in accordance withIslamic Economics. Currently, there are more than 350 banks as wellas nearly 300 mutual funds that practice Sharia compliant banking theworld over, managing wealth of above US$ 1trilion (Hassan, n.d). Inaddition, there are numerous non Islamic banks and other financialinstitutions spread around the world who also offer Sharia compliantservices to Muslim customers. Contrary to popular belief, Islamiccompliant financial institutions are not unique to Islamic countries,but are spread throughout most major economies. For instance, thelargest Islamic banks are spread in various regions, includingUniversity Bank in Michigan, the Islamic Development Bank withsubsidiaries in Turkey, Saudi Arabia, and the various Iranian banksholding the largest portfolio of any country as far as Islamicbanking is concerned (Hassan, n.d).

Inits basic construction, Islamic finance is based on equality ofwealth distribution among a market population. In its basicconstruction, an Islamic bank’s main objective, like that of anyother bank, is to make money from investing the money in itsdisposal, including but not limited to, depositors funds. However,contrary to ordinary banks that lend out money to customers andcharge a direct, predetermined interest on the amounts owed, Islamicbanks do engage the borrowers, often or always existing accountholders, in a manner as to establish a risk sharing agreement betweenthe bank and the customer. This means that in the event of a lossarising within the course of investment of the funds issued by thebank to the borrower, both parties will partake of the risk[ CITATION Gul08 l 1033 ].Ordinary banks, on the other hand, have no other obligations towardsthe borrower other than to provide funds to the borrower on thebank’s terms, and the borrower is obliged to meet their loaneeobligations towards the bank, usually under high defaultramifications. In this case therefore, ordinary banks are keen totransfer the entire risk arising from the borrower’s usage of themoney to the borrower, regardless of contingencies that are beyondthe investor’s foresight. Sharia banking,on the other hand, emphasizes risk distribution while ordinarybanking enhances risk transfer. The principles discussed below allowSharia banking to distribute risk (Venardos, 2010).

2.9.1Mudarabah

Thisis a financing arrangement where a bank (funder) enters an agreementwith an investor (borrower) in which both parties earn a profit frominvestments. In its basic form, this arrangement has the bank provideall the capital needed in a business venture, while the investingpartner provides all the expertise and time needed for theinvestment. Thus, this arrangement defies the concept of a loan inthe ordinary sense, even though the bank still issues out the moneyand the borrower still gets to invest all the money[ CITATION Jof10 l 1033 ].Contrary to ordinary banking arrangement, however, the bank mustretain full monitoring of the funds it entrusts to the investor,since in the event of a default the bank would lose all the moneylent. The investor, on the other hand, is likely to go through verythorough scrutiny before being pre-qualified as an investmentpartner, and even tougher scrutiny in the course of investment of thefunds. Thus, under such an arrangement, both parties are bound toremain very devoted to the success of the venture, but the bank allthe more for it has the greater value at risk. In Mudarabah, banksare very careful and skeptical in evaluating people who approach themfor investment financing, and the borrowers too very careful inselecting investment options before approaching the bank (Venardos,2010).

Theprofits arising from the investments are shared in a pre-negotiatedratio between the bank and the investing partner. Similarly, lossesare met by both partners in a prenegotiated arrangement. For allmanner of lending in which the bank transfers risk to the borrowertherefore, Mudarabah would disqualify the financial relationship inthe initial stages. Such risk immunity is what fuels most crises, andcould therefore be easily managed through this arrangement. The mostsignificant downside of such an arrangement is that banks would notbe willing to engage in partnership arrangements in which risksharing is emphasized unless such arrangements are enforced by anauthority, such as a state authority (Askari, 2010).

2.9.2Murabahah

Mudarabahis the closest resemblance to asset finance in ordinary banking.Asset financing allows the bank to fund the purchase of goods by aborrower, and charges an interest on the funds given. Thisarrangement is accompanied by stringent terms of engagement whichgovern not just the terms and duration of payment, but theimplications that the borrower must face in case of default. In thiscase, the bank retains the mortgage identity of the goods so funded,or other form of ownership. In Mudabahah, the bank agrees to financean asset, where upon the borrower agrees to pay a certainpredetermined compensation to the bank for the time value of themoney so committed to the purchase. This money can be termed as aprofit, agreeable to both sides. Like in ordinary banking, theIslamic bank retains legal control over the asset until the entiredebt obligation is met by the borrower. Contrary to ordinary banking,however, the Islamic principle forbids the bank from advancingadditional charges towards the debt obligation in the event that theborrower is earlier or late in paying the debt (Askari, 2010). Suchrecovery is deliberated in separate arrangements with the borrower.In ordinary asset finance, the bank stamps heavy penalties to theinvestor for early or late payment of the loan, includingrepossession of the financed asset or other assets.

Aswill be discussed in detail in the following chapters, the numerousforeclosure instances of mortgaged houses in the US starting in 2006was the real beginning of the rapid asset devaluation in the UShousing scheme bubble, an event that culminated in the globalfinancial crisis. The foreclosure of houses under mortgage was doneby the financing banks because the borrowers could not meet theirimmediate debt obligations, mostly because most could not afford themonthly payments. Again, if the lenders were under the obligation byexisting law not to repossess the mortgaged houses only on the basisof default by borrowers to meet several months’ payments, the rapiddevaluation could have been delayed or slowed, allowing the system tofind other avenues of stabilization. Therefore, Mudabahah would havebeen a practical tactic to manage the looming crisis (Askari, 2010).

2.9.3Musawamah

Thisprinciple, unlike the other two already discussed, mostly is aboutthe relationship between two or more business entities on the samelevel, such as customers, but may also involve customers andfinancers in transactions involving sale of property. The underlyingprinciple in Musawamah is to emphasize the intrinsic value ofproperty before engaging in sale or purchase processes. In its basicform, a potential buyer and a potential seller meet over the proposedsale or purchase of an asset, and the two engage in purchase talkswithout the seller stating the selling price or other associatedcosts beforehand ( as is normally done in an ordinary sale bargain).The two sides evaluate the real or intrinsic value of the asset underconsideration, and only in the final stages of the deal is the sellerallowed to suggest a selling price. Because a seller and buyer areallowed to negotiate on a sale without reference to market prices forit, a commodity’s true value is more likely to be reached during asale bid. This is directly unlike the contemporary sale-purchaseprocess in which a seller states an offer price, and the buyerbargains downward. Such a system is vulnerable to market forces whichmay sometimes stamp a speculative price to items under sale. Lack ofemphasis on the intrinsic value of an asset or product on offer forsale is usually the most significant driver of an asset bubble, wherespeculators prey on the psychological element of unrealistic valueappreciation of a commodity in a short duration. As such was thestate of house sales in the US in the pre-crisis period 2002-2006,where speculative buyers did not consider the intrinsic value of theproperty they were buying, but rather only on the rising housingprices since the last decade. This illusion allowed them to expectthe trend to continue rising, and them to sell the property for muchmore within a short time. Musawamah principle could have cultivated aculture of seeking the true value of assets before selling and buyingright from the start, and thus could have helped to avoid speculativebubbles which culminated in the crisis (Askari, 2010).

2.9.4Bai Salam

BaiSalam in its fundamental aspect implies advance payment for goods tobe delivered. In essence, it is the very opposite of Credit DefaultSwaps (CDSs) are used in the pre- crisis securitization processes.Bai Salam prohibits one from entering into debt with a second partyin order to meet debt obligations with a first party. To ensure this,a person is thus required to pay the full extent of a purchase pricebefore a seller delivers an asset to them, in order to avoid chainborrowing which really just creates wealth depletion in a system. Aswill be discussed in detail in the next chapter, financial tools usedto finance the US asset bubble were designed specifically to transferrisk arising from engaging in unsecure business from the originatorsof the risk to other people, most of them distributed over a widesystem of collateralization spanning the entire global financialservices markets. Islamic principles forbid such arrangements withinindividual investors as within financial institutions. Bai Salam inaddition prohibits entry into a delivery upon full payment agreementwhere the items under negotiation are precious metals or currency. Itemphasizes on zero ambiguity on sales of goods under Salam, whereuponthe exact date, place and manner of delivery must be specified. Thenature of commodities admissible for trade through this method mustbe that they are exactly measurable or weighable, and the exact valuefor them determined with minimum doubt (Venardos, 2010).

2.9.5Musharaka al Mutanaqisa

Thisis a joint agreement between a bank and a barrower where the itemunder purchase is equivalent to a mortgage under conventionalbanking. Since Sharia rules prohibit simple for profit lending wherethere is total risk transfer, the bank and borrower can enter into anagreement with a borrower that allows both parties to share the risk.In the object of this principal, a bank which intends to finance ahome ownership plan proceeds to build or purchase a house for theborrower as a partnership between the bank and borrower. Then, theborrower occupies the house as an ordinary tenant, paying the agreedrent to the bank. The bank then calculates the amount due to thepartner in the pre- arranged share percentages as profit due torenting of the property. In addition, the borrower may continue tocompensate the bank a certain percentage of the capital invested bythe bank into the house until some a time as when the bank is fullycompensated and the partnership then ends, leaving the borrower anindependent home owner. Such a system, like the others discussedbefore, allow both parties to share the risk and the profits from afinancing activity, which is in line with the basic constitution ofSharia banking which emphasizes risk distribution as opposed to risktransfer. In addition, such an arrangement reinforces sound decisionmaking and discipline in carrying out trade (Venardos, 2010).

2.9.6Gambling (Bayu al- gharah)

Islamicregulations are clear on gambling it is prohibited. In the Quaran,it is unlawful to engage in activities or games of chance where moneyis involved. Bayu al- gharah is the term in Islamic financing thatmost appropriately describes unlawful transfer or trade of risk.However, risk is such an integral part of business and trade thatwithout it, all business would saturate with investors, and theprofits would reduce towards nil as the laws of demand and supply getskewed. Thus, to keep out just the right amount of people in anyparticular trade, risk is an essential component. Potential investorsare operating with the risk of losing all their capital in the eventthat competition is disproportionately high, and therefore have tochoose wisely. Islamic finance does realize and appreciate thisreality. It does not deny existence of risk, and does not thereforeforbid engaging in risky business. What it tries to do throughfinancial transactions regulations is irregular or unfair transfer ofrisk between two trading parties. In gambling, specifically, the lawcategorizes the amount of risk as excessive, and therefore unlawful.In particular, the word Gharar is defined under Islamic terms assomething which is uncertain, or an event involving two outcomeswhere the less favorable one is more probable. As might be expected,there has always been disagreement even between Islamic scholarsregarding the threshold of major risk. A person considers as risk anyevent whose negative outcome they are not able or willing to contendwith, where another person could consider the same event asinsignificantly risky. Nonetheless, any form of gambling isprohibited under Islamic financial rules. Gambling, in the literalsense, cannot usually be attributed to countrywide or worldwideeconomic crises, but the concealed activities of financialinstitutions or even entire governments can sometimes be demonstratedto have outcomes that usually result from gambling activities. Thismakes regulation of excessive risk transfer a mandate of anysovereign government (Venardos, 2010).

Islamicbanking has continually shown more innovative without violating theprinciples of shariah in the recent past, venturing into such areasas derivatives markets and equity markets. While conventional bankingis mainly not conversant with Sharia laws and therefore seldomaccommodates Islamic banking, more and more banks are currentlyestablishing policies that allow them to offer Sharia compliantfinancial services to Muslim customers. There are more than 100 bigequity funds dedicated to Islamic financing around the globe, andmore hundreds of smaller funds and investment groups. So progressiveis Islamic financing that in 1999, one of the largest stock exchangesin the globe, Dow Jones, introduced Islamic stock indexes. Thesection below will discuss in detail the circumstances leading to the2008-2009 global financial crises, and therefore show how Islamicfinancing models could have helped prevent it (Venardos, 2010).

3.0Chapter 3: Methodology

Thischapter will review the global financial crisis in detail andidentify the operational causes of the crisis. It will then reviewthe fundamental elements of Islamic finance in order to evaluate themand find out how well they would have solved the crisis, or preventedit.

3.1Global financial crisis

Theglobal financial crisis has been cited by many to be the worstfinancial crisis since the Great Depression. The crisis had a farreaching effect in most financial markets throughout the world, butespecially in the major economies. It started in the US with thenear collapse of several major investment banks, mortgage firms, andinsurance companies and soon spread out to Europe and Asia. Thischapter will discuss the major events leading to the collapse of theUS housing bubble.

3.1.1TheUS Housing Bubble

TheFederal Reserve treasurer allowed an influx of foreign funds between1997and 1999 to bridge the gap left in the US balance of paymentsover several decades. This influx made available in the US marketsfinance upwards of $650 million. The banks went into business andconceived a housing scheme in which low income people could accessmortgages to own homes, and use the homes as security while theyserviced the loans for many years. Property value in the real estatesegment has traditionally been seen to raise the world over. The UShouse prices, like everywhere else, have risen consistently withincrease in inflation, land value and cost of building. However, thepresence of abnormally high credit on offer to people whose creditrating and collateral was low made a large number of people take themortgages and own new homes. The average price of buying a house hadrisen by up to 187% in mid 2006 to peak at $554,000, the highest inhistory. The Economist Magazine in 2005 had indicated that housingprices in the US and Britain between 1995 and 2005 had risen by afactor of 2.2-2.3 (Venardos, 2010).

Thishouse ownership option was made a favorite investment in the US afterthe Taxpayer Relief Act of 1997 allowed a once in two years exclusionfrom capital gains of $250 000 for a single person and $500000 for acouple when selling a home. This made home investment the onlyinvestment that escaped capital gains. Home sales could previouslyatteact as much as 30% in capital gains, greatly devaluing thereturns for the home owners. Thus, the new act changed investmentpriorities. In addition, the period between 2000 and 2006 was markedby very low interest on loans, following a decision by the governmentto stimulate the economy through investments. The Housing andCommunity Development Act of 1992 also contributed to the housingbubble that peaked in 2006. In this Act, two institutions establishedby the government to facilitate the acquisition of cheap, affordablehousing were established. The two institutions were Fannie Mae andFreddie Mac. In the 1992 Act, it was required that 40% of all loansgranted by Fannie Mae and Freddie Mac be dedicated to affordablehousing. In addition, subsidiary legislation in 1996 directed thatboth institutions should grant 42% of their mortgage finance topersons whose income was lower than the median income in their area.By 2005, this percentage had increased to 52%, which resulted inFannie Mae and Freddie Mac announcing low income loans for the lowerincome segment amounting to $5 trillion in long term. To grant thismuch, the companies had to lower the industry standards in lending,potentially opening gates of subprime lending from within them. Thedecision to avail housing finance to poorer neighborhoods wasreinforced also by the federal government, which consequently failedto regulate the Community Reinvestment Act. In effect, the cumulativenumber of low income persons accessing loans soon rose out ofproportion to the sector growth. In a few years, a significant numberof mortgage home owners started to default on the periodic paymentsbecause they could not afford them.

Normallyin the finance sector, a loan is classified as prime when the loaneehas demonstrated good ability to repay the loan as stipulated in thelending agreement, and subprime loans as those in which the loaneelacks a proper collateral and is much more liable to default. In theUS housing scheme, however, the Federal Reserve generalized thedefinition of prime and subprime loans using the nominal interestrates in the market alone. Normally, subprime loans are more riskythan prime loans, and therefore attract a bigger penalty. Therefore,in an ordinary market, the use of interest rates alone can give agood guidance regarding the type of loan. However, the banking andfinancial services industry in the period just before the crisis hadbeen disproportionately arranged with all loans interests generallylow and rating agencies mis-rating the various loans and investmenttypes. The Federal Reserve labeled as subprime only those loans whoseinterest rates were 3% higher than the nominal market rates. Thismeans that even the Federal Reserve mis-interpreted the status ofloans given to home owners. Investigations after the crisis haverevealed that the two public companies reported as sub-prime lessthan 10% of all subprime loans they had, which distorted thesituation in the mortgage backed asset finance for more than half adecade.

Theinterest rates were themselves regulated by the Federal Reserve afterthe dot com crash in order to stimulate economic development.Historically low interest rates of just 1% were available forborrowers, and this was continued for so long, saturating the marketswith low interest cash and the banks with higher sales targets inorder to meet their annual loan based revenues. In 2005, interestrates had been adjusted upwards to 5.25%, and consequently alladjustable rate mortgages were adjusted upwards. When lending bankscontacted potential clients between 2000-2002, they had promised thatthe loans were flat rate and could not be changed. This rise by morethan 5% made it impossible for a huge number of mortgage customers toservice their premiums, leading to massive foreclosures by year 2007.In the one year Fixed Rate Mortgages, the interest rated had droppedfrom 7% to just 4% in 2005. The result of this decline in mortgagerates naturally resulted in an increase in house prices since morepeople could afford to buy them. Financial rates analysts havesuggested that the average home value may rise by up to 20% if thelong term mortgage rates drop by a mere 2% assuming every home owneris taking a Fixed Rate Mortgage, or by up to 50% if everyone takes aVarying Rate Mortgage. Shiller, 2009, has shown that the averagehouse price in the period between 2003-2004 grew by up to 45%, whilein certain localities such as San Diego, the price rose by up to 50%.

Stillthe Federal Reserve chairman Alan Greenspan maintained as late asyear 2006 that the US was not experiencing a national bubble as such,but only small localized bubbles. This adamancy by the government toacknowledge the existence of a crisis only served to accelerate thebubble. Government involvement in financial regulations is aparamount function which in Islamic countries is upheld because, inthe very basic component of governance, Sharia law is embraced. TheBush government policy aimed at making home ownership easier andwithin reach for all Americans. In line with this, the home ownershiprates in the US rose from 64% in 1990 to slightly above 69% by 2007,the highest ownership rate in US history. The price that was paid forthis immediate bubble which contributed only 5% to the overallpercentage affected the entire sector, a mistake that will take solong to recover. The real estate market in the US in general sufferedsignificantly after the bubble, and is still recovering to date.

Consumerdebts continued to escalate in the entire period of the crisis, as,more and more people opted in to the mortgage finance. They wereprepared neither for the rise in mortgage interest rates nor for theupcoming fall in home prices owing to the large number offoreclosures following the inability of thousands to pay for theirloans.

Thehousing market has also been affected in many areas, resulting inmany evictions, foreclosures and lack of employment. As thoseresponsible for the global financial crisis are being bailed out, theeffects are felt by everyone. The crisis has contributed to failureof many important businesses, falls in consumer wealth and asignificant reduction in economic activity resulting to the severeglobal recession in 2008[ CITATION Rob08 l 1033 ].

Thecrisis was triggered by interplay of liquidity and valuation problemsin the US banking institution in 2008. The collapse of the US housingbubble and the reversal of the mortgage boom in other developedcountries has had quite a great effect around the world. The valuesof securities tied to the US real estate pricing declined damagingfinancial systems globally[ CITATION Lah07 l 1033 ].

Otherproblems have also surfaced in the course of this collapse withweaknesses in many financial systems being discovered. This declinein housing prices led to great losses being reported by the majorfinancial institutions that had borrowed and invested heavily in US.Investors’ confidence was damaged impacting stock markets greatly[ CITATION Bri10 l 1033 ].Thestrength of banking institutions was eroded, credits tightened andinternational trade declined. Large losses in securities werereported in the late 2008 and early 2009.

Asthe housing disintegration progressed, credit tightened andinternational trade declined slowing many economies worldwide. Thishas seen many governments responding with fiscal stimulus, bail outsand monetary policy expansion[ CITATION Gul08 l 1033 ]Arguments put forward suggest that credit rating agencies andinvestors were unable to accurately evaluate the risk associated withmortgage related financial markets and policy makers were unable toidentify the role of financial institutions such as investments andhedge funds[ CITATION Gul08 l 1033 ].

3.2Background

Thecrisis was triggered by the global housing bubble disintegrationwhich hit its highest level in 2006 in the US lowering the values ofsecurities tied to real estate and as a result damaging financialinstitutions globally. Speculation led to more home owners seekingloans from banks as housing prices began to rise. The price of atypical American house had increased by 124% on average between 1997and 2006 [ CITATION Lah07 l 1033 ].The appreciating prices and lower interest rates triggered anincrease in mortgage though income generating projects were not ableto grow at the same rate.

Banksencouraged home owners to take on loans optimistic that they would beable to pay them back quickly overlooking the interest rates. Theinterest rates began to rise in mid 2007 leading to a decline inhousing prices significantly. The speculative bubble was difficult tosustain by 2003 and by 2008, the decline in the average US housingprices was over 20%[ CITATION Lah07 l 1033 ].

Refinancingbecame increasingly hard resulting to a rise in the number offoreclosed homes. Lowering of interest rates backed by the US FederalReserve from 2000 to 2003 from 6.5 % to 1 % provided simple creditconditions leading to increased borrowing. This easy creditconditions prior to the crisis fueled the housing construction boomand encouraged debt financed consumption. The US was experiencing ahigh and rising current account deficit which pressurized lowering ofinterest rates as US required to borrow money from outside countries.The situation created a demand of different types of financialassets, the rising of their prices and reduced interest rates[ CITATION Jof10 l 1033 ].

Theeasy credit conditions allowed borrowers with weak credit historieswith a greater risk of defaulting to increase. This sub-prime lendinghas been viewed as one of the causes of the debt crisis. Mortgagefrauds have been confirmed and predatory lending has also been viewedas causes of this financial crisis. Further, it has been argued thatthe regulatory framework was not able to keep up with the pace offinancial advancements. Some laws were bypassed and their enforcementweakened in parts of the financial system[ CITATION Adi11 l 1033 ].

Asthe housing bubble expanded, the US households and financialinstitutions became increasingly indebted as a result ofover-leverage contributing to its collapse. The use of adjustablerate mortgage, mortgage backed securities, credit default swaps,collateralized debt obligations and other complicated, modernfinancial innovations were expanding becoming leading causes of thedebt crisis[ CITATION Bri10 l 1033 ].Financial agreements called mortgage-backed securities andcollateralized debt obligations which derived their value frommortgage payments and housing prices greatly increased. Thesefinancial innovations enabled investors and institutions around theworld to invest in the US housing market.

However,market participants failed to precisely evaluate the risks associatedwith such financial innovations. They were not able to assess itsimpacts to the economy and the overall financial system[ CITATION Rob08 l 1033 ].The decline in housing prices left major global financialinstitutions that had borrowed to invest in the subprime MBS countingsignificant losses. These great losses left many banks with verylittle funds to continue with their operations.

Thedeclining prices also resulted in houses valued at less than themortgage loan, providing a financial incentive to enter foreclosure.This foreclosure has been ongoing and it continues to drain wealthfrom consumers and the strength of banking institutions continues tobe eroded. Other parts of the economy have also been affected anddefaults and losses on other forms of loans also rose significantlywith the expansion of the crisis from the housing market.

Figure1: TED Spread between 2008-2009

TheTED spread (in red) increased significantly during the financialcrisis, reflecting an increase in perceived credit risk.

Variousother factors other than the housing and credit bubbles growthcontributed to the increased financial inflation. These caused thefinancial system to expand and become increasingly fragile, a processcalled financializaton. The regulatory framework was not able to keepup with the pace of financial developments[ CITATION Bri10 l 1033 ].Deregulationhas been emphasized by the US government policy to encourage businessand this resulted in less disclosure of information concerning newbusinesses the banks were involving in. Less oversight of financialinstitutions was also observed. Laws were bypassed and theirenforcement weakened in parts of the financial system.

Policymakers were unable to identify the role of financial institutionssuch as investments and hedge funds also referred to as the shadowbanking system. Even though these institutions were a source ofcredit to the US, they were not subject to the same laws governingcommercial banks. They assumed large debt burdens by providing loansbut they lacked a financial support to deal with the large loandefaults and losses. Economic activity was slowed and the lendingability of financial institutions was greatly impacted by theselosses[ CITATION Ewi10 l 1033 ].

Centralbanks had to provide funds to restore faith in stock markets andencourage lending which are integral in funding business operations.The government had to rescue the situation by implementing economicstimulus programs resulting to added financial commitments[ CITATION Gul08 l 1033 ].

3.2.1Subprime lending

Subprimerefers to the credit quality of certain borrowers who have weakcredit histories and a higher risk of default than prime borrowers.High competition between lenders for market share and revenue and theshort supply of creditworthy borrowers caused mortgage lender toprovide risky mortgages to less credit worthy borrowers. The easycredit conditions allowed borrowers with weak credit histories with agreater risk of defaulting to increase.

Thesecompetitive pressures as well as easy credit conditions contribute tothe increase of subprime lending during the years prior to thecrisis. Government Sponsored Enterprises (GSEs) relaxed theirregulations in order to keep up the competition with private banksand together with major US banks played an important role in theexpansion of lending. This sub-prime lending has been viewed as oneof the causes of the debt crisis[ CITATION Rob08 l 1033 ].Further,it has been argued that the regulatory framework was not able to keepup with the pace of these financial advancements. Some laws werebypassed and their enforcement weakened in parts of the financialsystem.

3.2.2Expansion of the housing bubble

Theglobal housing bubble disintegration peaked in 2006 in the USlowering the values of securities tied to real estate and as a resultdamaging financial institutions globally. The price of a typicalAmerican house had increased by 124% on average between 1997 and2006. The appreciating prices and lower interest rates triggered anincrease in mortgage though income generating projects were not ableto grow at the same rate. The speculative bubble was difficult tosustain by 2003 and by 2008, the decline in the average US housingprices was over 20%[ CITATION Lah07 l 1033 ].

Thisdecline in housing prices led to great losses being reported by themajor financial institutions that had borrowed and invested heavilyin US. Investors’ confidence was damaged impacting stock marketsgreatly. The strength of banking institutions was eroded, creditstightened and international trade declined. Large losses insecurities were reported in the late 2008 and early 2009[ CITATION Bri10 l 1033 ].

3.2.3Easy credit conditions

Loweringof interest rates in the US from 2000 to 2003 from 6.5 % to 1 %provided simple credit conditions leading to increased borrowing. Thesituation created a demand of different types of financial assets,the rising of their prices and reduced interest rates.TheUS was experiencing a high and rising current account deficit whichpressurized lowering of interest rates as US required to borrow moneyfrom outside countries. An inflow of foreign funds was needed toallow it to balance its current account and its capital account.Foreign investors were ready to lend either because of high interestrates (as high as 40% in China) or because of high oil prices.Foreign governments provided funds by buying USA Treasury bonds andthereby avoiding much of the impact of the crisis[ CITATION Adi11 l 1033 ].

3.2.4Predatory lending

Thepractice of lenders enticing borrowers to get into unsecure loans forinappropriate purposes has been seen as a contributing factor to thefinancial crisis. The most common method used was the advertising ofloans at low interest and later charging borrowers higher. Theconsumers would be put into an Adjustable Rate Mortgage (ARMs) wherethe interests charged would be higher than the interests paid thoughthe advertisement might state that the interest charged would be 1%or 1.5%. This resulted to negative amortization which borrowers mightnot realize until after completion of the transactions[ CITATION Bri10 l 1033 ]

3.2.5Deregulation

Regulatoryframework was not able to keep up with the pace of financialadvancements such as the importance of shadow banking. Some laws andregulations were bypassed or changed and oversight in enforcement wasabsent in parts of the financial system[ CITATION Rob08 l 1033 ].Restrictions on banks’ financial activities were not emphasizedallowing banks to rush into real estate lending and other activitieseven as the economy soared(Briggo,2010).

3.2.6Over-leveraging

Inthe period preceding the crisis, financial institutions became highlyleveraged increasing their risky investments and reducing theirabilities to deal with losses. Financial instruments such as offbalance sheet securitization and derivatives were used to make ithard for creditors and regulators to oversee and reduce the levels offinancial risks[ CITATION Sim09 l 1033 ].This contributed to the need for government bail outs as theinstitutions were not properly organized in bankruptcy.

Asthe housing bubble expanded, the US households and financialinstitutions became increasingly indebted as a result ofover-leverage. Their vulnerability to the collapse of the housingbubble was increased and worsened the following economic downturn(Briggo,2010).

3.2.7Financial innovations

Thisrefers to the ongoing development of financial products to meetspecific client objectives such as assisting to obtain financing. Theuse of adjustable rate mortgage, mortgage backed securities, creditdefault swaps, collateralized debt obligations and other complicated,modern financial innovations were expanding becoming leading causesof the debt crisis[ CITATION Bri10 l 1033 ].

Marketparticipants failed to precisely evaluate the risks associated withfinancial innovations like MBS and CDOs that were being usedexpansively in the years preceding the crisis. These innovations likethe shadow banking system and the off balance-sheet derivatives werea way of evading regulation. The market participants were not able toassess its impacts to the economy and the overall financial system.This resulted into great losses with many banks left with very littlefunds to continue with their operations[ CITATION Bri10 l 1033 ].

3.2.8Incorrect pricing of risk

Thepricing of risk refers to the amount of money for compensationrequired by investors for taking on additional risk. This may bemeasured in rates or interests. It has been argued that banks werenot transparent in exposing their risks before the crisis preventingmarkets from correctly pricing risks. This enabled the mortgagemarket to grow than it was necessary and aggravated the severity ofthe crisis than the case would have been if risk levels wereappropriately disclosed[ CITATION Bri10 l 1033 ].

Marketparticipants did not measure accurately the risks associated withinnovations such as CDOs and MBS for a variety of reasons. They alsofailed to understand its impact on the overall stability of thefinancial system[ CITATION Bri10 l 1033 ].As the complexity of financial assets increased and became moredifficult to value, investors were reassured by the fact thatinternational bank regulators and bond rating agencies were convincedby complex mathematical models which theoretically showed risks tobe smaller than their actual value.

3.2.9Rise and fall of the shadow banking system

Ithas been discovered that the riskiest mortgages were financed by theshadow banking system and competition from this system may have putpressure on some otherwise conservative institutions to lower theirown underwriting standards and originate their riskier loans[ CITATION Bru10 l 1033 ].

3.3Rise of commodities

Theprices of a number of commodities increased following the collapse ofthe housing bubble. This has been attributed mainly to thespeculative flow of funds from housing and other investments to othercommodities and some to economic policy. The price of oil has gone upover the past few years. This increase in oil prices tends to forceconsumers to spend a larger share on gasoline[ CITATION Gul08 l 1033 ].Thishas placed downward pressure on the economies of importing countriesas wealth increased in oil producing countries. The prices of oilover the last decade have not been stable and the destabilizingeffects of this price have been identified as a contributory factorin the financial crisis.

3.4Systemic crisis

Anotherexplanation of the crisis is that the crisis is only a symptom of adeeper crisis caused by capitalism. There has been a decrease in theGDP rates in the Western countries since the 1970s creating anincreasing surplus of capital that lacks sufficient and profitableinvestments in the economy. Placing this surplus into the financialmarket became the alternative since it became more profitable thancapital investment especially with subsequent deregulation. Thissituation has caused recurrent financial bubbles[ CITATION Sim09 l 1033 ].

Accordingto Ravi Batra’s theory, speculative bubbles that disintegrate andresult in depression and major political changes can also be producedby the growing inequality of financial capitalism. He has alsoproposed that a demand gap deficit and debt dynamics important tostock market growth can be explained by differing revenues andproductivity growth. Analysts have also suggested that the recenttechnological innovations such as computer based trading coupled withthe interconnected nature of markets has magnified the effects of thecrisis. This has created an unstable condition in the financialsector. Another explanation by economists is that the current creditconditions in the US can be attributed to stagnation of wages amongcasual laborers who comprise the bulk of the workforce forcing themto borrow in order to meet the cost of living[ CITATION Gul08 l 1033 ].

3.5Impact on financial markets3.6U.S. Stock market

TheUS stock was at its peak in October 2007 but entered a pronounceddecline which increased in October 2008. The stock market has howeverrecovered much of the decline markedly in the first half of 2011.

3.7Financial institutions

Estimatesby the International Monetary Fund (IMF) place the losses of large USand European banks at more than $1 trillion on toxic assets and badloans from January 2007 to September 2009. These banks are still notthrough with their losses with the IMF estimating that US banks are60% through their losses and those in the euro zone only 40%[ CITATION Bri10 l 1033 ].

Atthe beginning of the crisis, only institutions directly involved inhouse construction and mortgage lending were affected as they couldno longer access financing through credit markets. Many of thesemortgage lenders went bankrupt between 2007 and 2008. The peak offinancial institutions crisis came in September and October 2008 whenseveral major institutions failed, were taken over by governments orwere acquired under difficult financial situations[ CITATION Gul08 l 1033 ].

3.8Credit markets and Shadow banking system

Thecredit crisis is also explained by economists via the entry of theshadow banking system to the financial system. Shadow banking systemhad become extremely popular and was nearly as valuable astraditional commercial banking sector. Investment banks and otherinstitutions in the shadow banking system lacked the capacity toprovide funds to institutions and mortgage lenders. Therefore, theyhad to obtain investor funds in exchange for asset backed commercialpaper or mortgage backed securities. The collapse of the shadowbanking was responsible for the reduction in funds available forborrowing since traditional banks have raised their lendingstandards[ CITATION Bri10 l 1033 ].

3.9The Islamic World and the financial crisis

Reportsby the World Bank have shown that the Arab world is in the bestposition to deal with the economic shocks[ CITATION Sim09 l 1033 ].Thecountries were able to avoid going to the market for the larger partof 2008 since they had a relatively good balanced of paymentspositions getting into the crisis or having alternative sources offinances. The countries were in exceptionally strong economicpositions as they entered the crisis and hence were better cushionedagainst the global economic downturn.

However,lower oil prices will have the greatest impacts on the globaleconomic crisis as oil remains the single most important determinantof economic performance. They would be forced to draw from theirreserves and reduce their investments if oil prices decline steadily.Economic performance would be reversed in the event that oil priceswould be significantly low. In this increasingly interconnectedworld, the crisis has also exposed Asian countries to problemsstemming from the West[ CITATION Gul08 l 1033 ].

4.0 Chapter 4: Analysis of findings

Thischapter will draw from the findings in the previous chapter and usean appropriate Islamic principle of financing to demonstrate how asolution could have been possible in the last crises, as well as howwell the principle can be used in the future.

4.1Islamic Financing Solutions to Financial Crises

Islamicfinancing methods are properly tuned for growing economies that areobjective, controlled and progressive without having to worry overartificially created bubbles and downturns where only a few benefitfrom the wealth of the masses. Islamic financing principles relyheavily on risk sharing rather than risk transfer, on almost fullreserve banking as opposed to very high depositing lending, onutilization of one’s assets to do business rather than reliance onhigh leverage and borrowing to invest, and on prohibition of anyactivities consistent with gambling such as creation of credit swapcommodities and transfer of risk through ambiguous financial tools.The section below will discuss in detail the methods that Islamicbanking applies to prevent financial crises.

AlreadyIslamic banking is on rapid growth, being the most rapidly growingmarket sector at 15-20% annually. By the beginning of year 2009,funds invested in Islamic equity market reached $4.3 trillionaccording to the Dow Jones index. Equity funds held in Islamiccompliant practices are above the $1trillion mark. The reason behindthis progressive swell in Islamic financial products is due to theincreased trust with which investors hold the integrity andobjectivity of shariah compliant investment.

4.2Solutions to the Stock Market

Thestock market is not only one of the robust frontline sectors of aneconomy, but also one that most commonly links direct investors ofvarious countries. Thus, when financial crisis hit a country, it ismost commonly the stock market that is hardest hit. Sadly, the stockmarket is the one most prone to speculation and virtual wealthcreation. In the 2008-2009 crisis, the stock markets were swellingwith virtual derivative wealth, as much as 5 time the real wealth inthe world. Through the stock markets, financial engineers can createvirtual tools and commodities and proceed to trade them as if theywere real assets. Sadly, investors in the virtual commodities usereal equity to purchase them, hoping that the desired outcomes can berealized early enough so that the risk associated with theseinvestments can be transferred to the next person.

TheIslamic equity funds index was founded in 1998 under FTSE . More than15 years later today, the Islamic stocks index is flourishing, and iscategorized according to industry and region. The Global IslamicIndex Series (GIIS) comprises 48 indices based on region and 47 basedon country.

Toqualify for admission into the index, a company must have not morethan 33% of total assets as debt, meaning a leverage of not higherthan 0.33. conventional companies listed under major exchanges haveleverage values as high as 33,which translates to 1000 times morethan the requirement under Islamic law. The 30% limit ensures thatthe company will always operate using its own property for up to 70%of all its operations. In the event of a minor credit crunch orcrisis, a company whose capital operations are 70% self reliant wouldbe 23 times more stable than one whose capital reliance is only 3%(implying a leverage level of 33%). With such an arrangement, thescenario experienced in 2009 where dozens of major companies werereceiving bailout from governments to avoid bankruptcy and insolvencywould be very unlikely even in credit scenarios slightly worse thanthe global financial crisis. To control risk appetite especiallyusing depositors’ money, governments should enforce an almost fullreserve banking model, where if banks have to invest money in riskyprojects, they must invest only money obtained through other avenues,such as profit re-investment or shareholder contributions, but neverusing depositors’ funds. In addition, no companies in the publicdomain should borrow funds from whichever source to exceed one thirdof their total assets.

Anotherrequirement under the Sharia compliant GIIS system is that no companywith cash or interest bearing items more than 33% of their totalassets, or account receivables and cash higher than 50% can beadmitted. This requirement discourages a company’s reliance oncash, given the tendency of cash to fluctuate with fluctuations ininternational currency. The devaluation of a country’s currencyduring an international recession or fluctuation has oftencontributed to bankruptcy of companies that are largely reliant onforeign exchange. Islamic finance has foresight of this scenario, andis determined to protect investment companies from downfall arisingfrom their own negligence (Arthur, n.d).

Thenext item under Sharia compliant GIIS is the prohibition ofengagement in sale of goods or services forbidden under shariah law.This section need not become applicable to non Muslim basedcompanies, except where it concerns certain services generallyapplied in the market, and as such may not have any real bearing onthe performance of a company, economy or government in its effort toavoid a financial crisis. The items forbidden under law are sale ofpork or pork related products, tobacco, and alcohol among others.While the trade in these items is not necessarily detrimental to thewider market performance, the engagement in the trade of gamblingactivities is. Gambling is prohibited in Islamic practice, whetherdirectly through literal games of chance, or disguised in legitimatetrade activities. The particular element of gambling prohibited underIslamic law is the unfair or unjustified transfer of risk. Thisobviously prohibits the trade in risk itself, as is the underlyingelement in popular market commodities such as Collateralized DebtObligations (CDOs) and Credit Default Swaps (CDSs). These productswere at the frontline of the global financial crisis, and could wellbe the sole reason so much wealth was lost. Collateralized DebtObligations (CDOs) were groups of loans and risks including studentloans, mortgages, car loans, home appliance loans, investment loansand other loans, which were bundled together as one loan with thename CDO and sold to investors all over the world by investmentbanks, with the promise that high returns would be gained by theinvestor whenever premiums on each of these loans were delivered. Inturn, the investment banks selling CDOs would insure them with majorinsurance companies such as AIG, who was supposed to compensateinvestors whenever each of the CDOs sold to them was defaulted andthey could not recover their investment. This in itself was transferor risk. Risk is tolerated under Islamic finance insofar as itssource is justified and unavoidable, and it is distributed equally orproportionately among everyone who would benefit from its absence.Investment banks were selling loans they did not actually have, byacting as brokers or middle agents between investors who want returnon capital invested, and loan borrowers who were hungry for funds touse and pay later (Arthur, n.d). Coincidentally, the CDOs were mostprevalent when the country was having one of the lowest interestrates set by the Treasury, making it apparent that credit wasaffordable to borrowers. Thus, whenever an investor bought a highreturn CDO, they were indeed just buying the risk of another loaneebeing unable to meet their debt obligation, and leaping benefitswhenever the borrower managed to pay. Islamic principles forbidtransfer of debt, or buying goods one can’t pay. It is emphasizedthat one must use money to pay fully for goods or services sopurchased. Under this law, therefore, the trade in debt as is thecase in CDO markets would be prohibited. This would eliminate therisk of avalanche collapse of systems owing to buildup of debt, andaffluence of borrowed funds for use today with no clear method ofpaying the debt in the future. As it were, the global value of CDOsin the wake of the crisis was more than five times the total globalassets. CDOs, without proper and timely regulation, are like pyramidschemes where the wealth of the majority is concentrated in a smalltime and utilized, with the larger system losing the equivalent ofwhat a few people gain in the short period before the schemecollapses. Unfortunately for the global financial crisis, thecompanies who lost money rushed to the government for bailout in2009, and the government immediately signed bailout papers for closeto $700 million to protect the companies (Arthur, n.d). Ultimately,the debts incurred due to careless risk appetite were paid by the taxpayer. The Islamic system of finance is clear on this aspect that noone is allowed to transfer risk due to their own action to be paid byanother person. Such a system in place would have prevented theglobal crisis because engagement in risk trade would not havehappened in the first place, and in any case persons engaging in suchwould have to pay for their mistakes without bailout. The Islamicmodel regarding CDOs would eliminate the bulk of them, and ensurethat all activities that are potentially risk based would be closelyregulated by the government to ensure that they do not go beyond apre-set safe threshold where the event of risk occurrence or systemcollapse would not significantly affect the wider economy. Any formof debt obligations need to be audited by independent experts whoevaluate the best and worst case scenarios, and ensure that any formof risk transfer is statistically not beyond a safe threshold even inthe worst case scenario. For instance, in the global financialcrisis, even a basic statistical analysis would have shown thatinsurance companies were unable to meet compensation demands arisingfrom insurance of CDOs and CDSs for even a mere 5% total claims,which given the volatile nature of these products, would haverealized the risk in their investment, and therefore immediatelyordered a system audit to evaluate viability of the CDO schemes.

Inaddition to CDOs, the investment experts went ahead to model productsthat directly dealt with trade in risk, in form of Credit DefaultSwaps (CDSs). Credit Default Swaps were essentially the opposite ofCDOs. CDS sellers approached investors who believed that loan bearerswould default on their premium payment, and proceeded to promise topay the investor every time a loanee in question failed to pay theirpremium. Therefore, in effect, CDS was like a gambling item, with aperson getting paid every time another person failed to meet theirdebt obligation. Surprisingly, the same companies that were sellingCDOs also started selling CDSs, meaning they did not believe in thesame products they were selling. Through these products, thegovernment was encouraging betting and gambling on large scale, whereto make matters worse, the clientele induced into the gamblingbusiness were fully unaware of the risks in it because they trustedthe government and rating agencies, all of which continued to denythat the economy was at risk due to credit trading. To this end, thefailure can be totally attributed to the government for failing todemonstrate a proactive method of controlling the financial marketseven when clear evidence existed to show that the current creditbubble was unsustainable and detrimental to the long term economicperformance. The US government had long been in control of financialmarkets for decades, but the combined effect of more than three Actsof parliament written in the last century was thorough deregulationof financial markets where banks were allowed to speculate usingdepositors money, to lower their reserves to unprecedented lowlevels, and to borrow as much as they could to increase theirleverage. These Acts included the Deregulation and Monetary controlAct of 1980, the Garn-st Germain Depository Institutions Act of1982,and the Gramm Leach Bliley Act of 1999. Thus abandoned, the financialsector progressed into a wanton period of greed and risk taking,which resulted in the crisis. In contrast, Islamic finance is closelylinked to national values of objectivity, real value creation asopposed to virtual wealth creation, risk distribution as opposed torisk transfer, and a moral basis to trade. It simply calls for areturn to the days where the stock markets and banking sectors wereclosely monitored by the government to protect the interests ofindividuals putting their trust in the banks. Even though therequirements of an Islamic like model may seem stringent, therationale behind the tight requirement is the wider good of theinvestors, the economy and the entire world. While countries do notneed to convert their financial system to use Islamic terms, they cancopy the ideals based on Islamic finance to enable longevity ofgrowth. It is worth to note that any system will gain more in thelong term through regulated operation than through a self-interestbased system.

Konstas(2006), gives a detailed account of how American economists attemptedto suggest to the government that the financial system based on nilreserve banking and collateralized banking was like an invertedpyramid with debt and virtual wealth outweighing GDP sometimes by afactor of up to ten, and that the system was bound to collapsebecause real economic productivity, which is at the base of thepyramid and is supposed to pay the debts accumulated higher in thepyramid, was smaller than the debts. The Federal Reserve chairmanAlan Greenspan, however, maintained that the credit system was stableand did not need any immediate re-organization that the smalllocalized credit bubbles would end on their own. He only admittedthat there was a problem so much later when damage had already beendone. Such reflects the opaque outlook that governments have showntowards unsound financial decisions.

Regardingthe risk spread between banks and borrowers, western economies areabsolutely skewed in the side of the borrower. The banks provide onlythe capital with which to do business for the borrowers, and demandthe full share of repayment by the customer, at whatever cost andregardless of the circumstances. The example of the housing bubbleand its aftermath is a perfect demonstration of risk aversion byconventional lenders. Customers took mortgage loans with the bankswhen interests were as low as 3%. The federal government adjustedinterest rates to curb inflation 12 times between 2004 and 2007,raising it to almost 6%. Thus, the initial borrowing conditions forall the thousands of homeowners who were working overtime to financetheir monthly premiums were altered against their expectations andadjusted upward. The government was not concerned about all thepeople who had accessed subprime mortgage backed loans, and didnothing to intervene when they became unable to pay their monthlypremiums. Instead, banks were quick to declare foreclosures on houseswhose premiums were not met in effect making hundreds of thousandsof loanees lose their investments and savings once their propertieswere repossessed by financers. The Islamic model of riskdistribution would have intervened to prevent the numerousforeclosures from happening. According to Shariah compliant banking,mortgage type financing can only happen where the bank and thepotential home owner are actually partners, not bank and borrower asin the case of ordinary mortgage arrangements. The banks would haveowned all the property that new homeowners were borrowing money tobuy, and then the banks would either lease the property to thecustomer or jointly own the property with the buyer who would thenproceed to occupy the house for a rent. Once the tenant paid themonthly rent, the bank and the buyer (who is also the tenant), wouldsplit the rent in proportion to the nature of initial financing. Thebuyer would also run a parallel arrangement to give the bank apremium each month towards full ownership of the home until such atime as the mortgage is fully met. In the other arrangement wherethe loanee is a tenant in the house, the bank would continue tocollect rent from the tenant, including a portion of the cost of thehouse in excess for the purpose of the time value of the bank’sinvestment, until such a time as the rent premiums have met the fullcost of the home. In the event of a default, the bank would lose itsinvestment in the home capital. This would discourage the bank fromissuing loans to persons with no demonstrated ability to fullyservice their loan even in the case of increment of interest rates.

Therefore,in accordance with the Islamic model of financing, any bank declaringa foreclosure would be required to meet the larger part of thedefaulted amount in accordance with non interest regulations underShariah law. This way, risk would be distributed in ratio to thecontributors or partners. Conventional banking should embrace riskdistributed financing as opposed to risk transferred financing.Proper checks and balances should be put in place, and Acts ofparliaments enacted to safeguard the interest of equitabledistribution of risk among partners. Banks should not lend money fora mere interest, and where such an interest exists, regulationsshould be enacted to prohibit variation of interest rates once afinancial arrangement between a bank and a borrower has beenfinalized. This way, borrowers would enter into a loan repaymentagreement knowing the full extent of the interest payable by them,and consensually opting to take it. This will prevent high levels ofdefault which deprive investors of all money and time already devotedto payment of loans, and therefore reduce the huge losses thatfinancial sector incurs through the default consequences.

Thewider economy also suffers greatly when banks give subprime loans tocustomers. When so many loans are given, the cash circulating in amarket increases, thus devaluing the currency and increasinginflation. This in turn costs the country in terms of currencystability, foreign exchange earnings and leads to high cost ofliving. Correcting the effects of inflation require strictderegulation which leads to lowered investment opportunities, andlower access to capital. Banks can control this through evaluatingthe nature of loans that they give to customers, and their creditrating. Only persons with demonstrated ability to repay loans shouldbe given loans, unless express initiatives have been put in place toavail loans to low income earners, and the state provides backing incase of default by the customers. Again, the Islamic model emphasizesrisk sharing as the most effective method of controlling subprimeloans, since banks will be the largest losers in events of default.

5.0Chapter 5: Conclusion

Islamicbanking provides a workable solution to global financial crises. Itprovides dependable solutions to all the commonly established sourcesof crises, including lack of government regulation, risky bankpractices of fractional or nil reserve banking, the conventionalelement of risk transfer in ordinary banking, and the tendency ofunregulated investors to engage in gambling through formulation ormultiple financial commodities that transfer risk in unfair ways toconsumers. While no country or economy needs to convert its bankingsystem to Islamic based, nor its population to Muslims, theprinciples of Islamic banking are easily adaptable by anyinstitution, organization or economy with results being just as good.

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