Islamic Financial Perspective to Overcome Financial Crisis

FINANCIAL CRISIS 61

IslamicFinancial Perspective to Overcome Financial Crisis

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.

Keywords: Financial crisis, Islamic banking, Arabic world, financialsector.

Contents

Executive Summary 6

1.0 Chapter 1: Introduction 9

1.1 Research Problem 9

1.2 Research Objective 9

1.3 Research Scope 10

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 12

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 21

2.8 Causes of financial crises 21

2.8.1 Lack of regulation 22

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 30

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 38

3.2.2 Expansion of the housing bubble 44

3.2.5 Deregulation 45

3.2.6 Over-leveraging 45

3.2.7 Financial innovations 46

3.2.8 Incorrect pricing of risk 46

3.2.9 Rise and fall of the shadow banking system 47

3.3 Rise of commodities 47

3.4 Systemic crisis 47

3.5 Impact on financial markets 48

3.6 U.S. Stock market 48

3.7 Financial institutions 48

3.8 Credit markets and Shadow banking system 48

3.9 Financial crisis and the Muslim Wolrd 49

4.0 Chapter 4: Analysis of findings 50

4.1 Islamic Financing Solutions to Financial Crises 50

4.2 Solutions to the Stock Market 51

5.0 Chapter 5: Conclusion 59

References 60

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 investment companies wasspread throughout the universe, with similar ramifications felt inmajor European economies and elsewhere in the world. The estimatedtotal losses due to this credit depletion was in excess of $1trillion, with the bulk of the losses being met by governments fromtaxpayers money, as well as direct investment losses for millions ofinvestors (Justin,2007).No Islamic bank or mainstream institution was significantly directlyaffected in the 2008-2009 crisis, as interest driven speculativelending is prohibited 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 paper will focus mainly on the contributing causes of majorfinancial crises with a special focus on the Global Financial Crisisof 2007-2009 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 and 2009 pages 41

Figure2: Subprime lending and home ownership in the US between 1990 and2006 page 43

  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. One outstanding realizationin the last crisis is that Islamic economies were not as hard hit asother economies, and even then they were only indirectly affected dueto overreliance on oil trade, a commodity whose exchange basecurrency is still largely the dollar and whose main markets are stillwestern countries and China. However, no extensive research has beenmade to discover the reasons why Islamic nations’ credit marketsremained intact, and whether the principles they employ are viable ona wide scale to prevent crises. This paper will explore the world ofIslamic finance with a view to find out applicability of its conceptsto 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 to introduction of money, the system of taxation andmarket regulation was founded. The market based financial systemcontinued to thrive driven by demand and supply forces. The issue ofresource depletion and scarcity was a driving force for thecompetition, and consequently government intervention in terms oftrade laws. In line with this, some markets emerged as capitalist,while others favored a communist system. Capitalists encouraged theamalgamation of wealth through legally acceptable channels, whilecommunist systems favored a 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 avoid crises, governments have over timedefined conditions to be used. Different control methods areapplicable for different types of crisis. Financial crisis can beclassified either as banking crisis, speculative asset bubbles andcrashes, international crisis, or wider economic crisis. The methodsused to regulate each type may vary, but usually more than one typeof cause is involved. In the 2007-2008 crises, for instance, the UShousing bubble was the original cause of the chain of events. Thisbubble was further aggravated by the availability of cheap creditwhich local financial institutions were pushing to anyone willing toown a home, a credit bubble thus resulted (Simkovic,2009).Lack of proper credit securitization peaked in 2008, and wheneveryone realized that the asset scheme was unsustainable, the homeownership proxy which was at the middle of the entire credit scamswiftly lost its appeal, leading to massive devaluation of assets.This led to several banking crises within major countries, whichaffected the economic sector globally- thus causing an internationalcrisis. The section below will explore the nature of each of thecrisis (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 banks would not be ableto pay off all depositors on demand, and would therefore be declaredbankrupt. Major banking systems have operated using a fraction-basedreserve banking, where a certain percentage of all deposits must beretained 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 banking sector.The great depression for instance, had multiple bank runs thathappened in 1929 to 1933, when investors massively withdrew theirdeposits from American private banks (Gordon,2008).The fractional reserve banking, which is a model that banks onlyretain a certain percentage of investors’ funds in reserves butinvest the rest in loans and securities are the system currently inuse in most countries. This implies that banks may invest depositors’funds to almost 100%, thus leaving them vulnerable to insolvency inthe event of a small depreciation in asset value. In the crisis of2009, some companies had attained leverage levels (or the ratio ofdebt to assets) of 33, meaning a mere asset depreciation of 3% wouldhave declared 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 of depositors money. Most ofthese rules were repealed over the century, giving banks more controlover their investments. In contrast Islamic banking law prohibitsinterest based lending, in line with the Quran (Gordon,2008).This essentially eliminates the greed for instant profit, an issuethat is almost always a contributing factor in banking and otherfinancial services malpractices. In the 2007 crisis, for instance,investment banks teamed with rating agencies to come up with abstractfinancial instruments called Collateralized Debt Obligations (CDOs)and Credit Default Swaps (CDS), that purported to spread risk in aninvestment market, while in the real sense these products heaped therisk on unsuspecting investors and a few insurance companies thatinsured 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. 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$ 1 trillion (Hassan, n. d).In addition, 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(Diya, 2008).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 ordinary banking enhances risktransfer. The principles discussed below allow Sharia banking todistribute 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(Josef, 2010).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 pre-negotiated 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 Quran, itis unlawful to engage in activities or games of chance where money isinvolved. Bayu al- gharah is the term in Islamic financing that mostappropriately describes unlawful transfer or trade of risk. However,risk is such an integral part of business and trade that without it,all business would saturate with investors, and the profits wouldreduce towards nil as the laws of demand and supply get skewed. Thus,to keep out just the right amount of people in any particular trade,risk is an essential component. Potential investors are operatingwith the risk of losing all their capital in the event thatcompetition is disproportionately high, and therefore have to choosewisely. Islamic finance does realize and appreciate this reality. Itdoes not deny existence of risk, and does not therefore forbidengaging in risky business. What it tries to do through financialtransactions regulations is irregular or unfair transfer of riskbetween 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.

3.1.1The US Housing Bubble

TheFederal Reserve treasurer allowed an influx of foreign funds between1997 and 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 previouslyattract 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 borrowerslacks 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 rating the various loans and investment typeswrongly. The Federal Reserve labeled as subprime only those loanswhose interest rates were 3% higher than the nominal market rates.This means that even the Federal Reserve misinterpreted 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 and 2002, they had promisedthat the loans were flat rate and could not be changed. This rise bymore than 5% made it impossible for a huge number of mortgagecustomers to service their premiums, leading to massive foreclosuresby year 2007. In the one year Fixed Rate Mortgages, the interestrated had dropped from 7% to just 4% in 2005. The result of thisdecline in mortgage rates naturally resulted in an increase in houseprices since more people could afford to buy them. Financial ratesanalysts have suggested that the average home value may rise by up to20% if the long term mortgage rates drop by a mere 2% assuming everyhome owner is taking a Fixed Rate Mortgage, or by up to 50% ifeveryone takes a Varying Rate Mortgage. Shiller, (2009) has shownthat the average house price in the period between 2003 and 2004 grewby up to 45%, while in certain localities such as San Diego, theprice 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.

Thehousing market is among economic sectors that were heavily affectedby the financial crisis that occurred in the year 2008. The impact ofthis crisis on the housing market increased the rate of unemployment,foreclosure, and eviction. Although the government has been using thepublic funds to bailout firms that were directly responsible for theoccurrence of the crisis, it is evident that the impact was felt bynearly all businesses. Many businesses collapsed, the consumer wealthreduced, and the overall economic activities declined (Gordon, 2008).

Thecrisis was generated by the interplay of liquidity and valuationproblems in the U.S. banking sector a few years before 2008. Thebursting of the housing bubble in the United States and the reversalof the mortgage boom in other developed countries had a great effectaround the world. The values of securities tied to the U.S. realestate pricing declined damaging financial systems at global level(Justin, 2007).

Otherproblems have also surfaced in the course of this collapse withweaknesses in many financial systems being discovered. The decline inhousing prices led to great losses being reported by the majorfinancial institutions that had borrowed and invested heavily in U.S.Investors’ confidence was damaged impacting stock markets greatly(Briggo, Pallavicinni, &amp Torresetti, 2010).The strength of banking institutions was eroded, credits tightenedand international trade declined. Large losses in securities werereported in the late 2008 and early 2009.

Manygovernments have been responding to the issue of the rapiddisintegration of the housing market through bailouts, fiscalstimulus, and monetary policy expansion (Diya 2008). Failure byinvestors and the credit rating firms to assess the financial riskassociated with the mortgage market is one of the major factors thatcontributed towards the occurrence of the crisis. Consequently, thefinancial crisis occurred as a surprise to the key players in theeconomy who were expected to shield the national economy as well asthe global economy from such misfortunes.

3.2Background

Theoccurrence of the financial crisis has been attributed to severalfactors, but the housing bubble that was at its peak in 2006 was theprimary cause. The housing bubble resulted in a significant declinein securities’ value that was associated with the real estate,which in turn damaged the financial sector at global level. The rapidincrease in the housing prices tempted the house owners to borrowloans from banks. According to Justin (2007) the price of a typicalhouse in the United States rose by an average of 124 % from 1997 to2006. The rapid increase in prices couples with the decrease in theinterest rates resulted in a significant increase in mortgage, butother income generating activities could not match or grow at thesame pace.

Thecontinuous increase in the price of houses gave confidence in backsthat borrowers would be able to service their loans withoutconsidering the effect of the interest rate. Surprisingly, theincrease demand for loans triggered an increase in the rate ofinterest, which was followed by a significant decline in the price ofhouses in 2007. The stakeholders were unable to sustain the housingbubble in 2003 and the housing prices had started declining at about20 % in the year 2007 (Justin, 2007).

Thedecrease in the rate of interest from 6.5 % in 2000 to 1 % in 2003resulted in an increase in the rate of borrowing (Josef, 2010). Theincrease in demand for borrowing encouraged debt financed housing andconsumption in the U.S. economy. This resulted in an increase indeficits in the U.S. current account, in turn pressurized theinterest rates since the government had borrowed from othercountries. This increased the demand for various financial assets,leading to an increase in their respective prices and a significantdecline in the rate of interest (Josef, 2010).

Thelenient borrowing conditions that were intended to increase thenumber of the American house owners increased the number of borrowerswith a higher risk of default. Consequently, the loan defaultersincreased and this crippled many financial institutions. Mortgagefrauds coupled with predatory lending are perceived to be the majorfactors that triggered the occurrence of the crisis. This is becausesome of the laws regulating the financial market were bypassed andthe government failed in its role of enforcing these laws(Chakrabortty, 2011). This reduced the capacity of the regulatoryframework to contain challenges associated with rapid financialadvancements.

Financialinstitutions and the households became increasingly indebted with anincrease in the expansion of the housing bubble. Investors preferredsecurities based on mortgages, mortgages with adjustable rates,collateralized debts, and default swaps, all of which exacerbate thecrisis (Briggo, Torresetti, 2 Pallavicinni, 2010). The housingbubbled resulted in the invention of two financial agreements(including mortgage-backed and collateralized debt) whose value wasmainly obtained through mortgage payments, which contributed towardsthe increase in the price of houses. The increase in the price ofhouses coupled with financial inventions attracted investors fromother parts of the world who got some interest in the United States’housing market.

Thekey players in the financial and the real estate businesses failed toforecast the risk that could arise from the new financial inventions.Consequently, most of the financial institutions that borrowed fundsto invest in the most promising subprime suffered financial loss,which culminated in the financial crisis (Gordon, 2008). Thefinancial institutions were left with little cash to sustain theiroperations. The continuous decline in the price of houses created ascenario in which the value of houses was less compared to that ofmortgage loans, which paved way for foreclosure. Since then,foreclosure has continued to drain consumers off their wealth anderoding the perceived strength of the financial institutions.

Figure1: TED Spread between 2008 and 2009

Theincrease in TED spread during the crisis reflects as shown in Figure1 reflects an increase in the credit risk

Apartfrom the housing and credit bubbles, there are other factors thatcontributed towards the occurrence of the financial crisis. Thecontributions of multiple factors resulted in a significant expansionof the financial system, which in turn increased the fragility of thesystem in a process known as financialization. Consequently, theregulatory framework that was in place at that time was renderedirrelevant by the rapid financial developments (Briggo,Torresetti, &amp Pallavicinni, 2010).The emphasis placed by the U.S. government on the deregulation of thefinancial sector created a gap for the financial institutions toavoid the full disclosure of the business they were engaging in.Consequently, the government oversight over the financialinstitutions was relaxed and this reduced the capacity of thegovernment agencies to detect and contain the pending financialchallenges at early stages of their development.

Apartfrom the banks and other established financial institutions, theshadow banking system also contributed a great deal of the creditused to finance the housing sector. However, the policy makers andthe stakeholders failed to perceive the role of this system becauseit was governed by different laws other than those that governed thebanks. Players in the shadow system increased their lending and,later failed to manage the increasing number of defaults, which madethem suffer huge financial losses (Jack, 2010). Central banks indifferent countries were forced to finance the stock market, with theobjective of encouraging lending and restoring investors’ faith(Diya, 2008).

3.2.1Subprime lending

Duringthe financial crisis, financial institutions were competing toincrease their revenues and market share. This tempted theseinstitutions to loan more funds to subprime borrowers who had ahigher risk of defaulting and weaker credit histories. The highcompetition for market share created a scenario in which mortgagersissued risky mortgages to borrowers who had less credit worthiness. Surprisingly, even the government sponsored enterprises were forcedto relax their lending rules in order to enhance their capacity tocompete with the players in the market (Gordon, 2008).

Figure2: Sub-prime lending

3.2.2The impact of the housing bubble

Thehousing bubble reached its peak in the year 2006 and it resulted inthe decline in the value of securities that had been attached to thereal estate (Justin, 2007). The high rate of appreciation of houses(by 124 % by the year 2006) coupled with decline in interest ratesincreased mortgages. However, other income generating activitiescould not grow at the same pace. The growth in house prices was notsustainable and its subsequent decline damaged the U.S. domestic aswell as the global economy. Many financial institutions, includingthe foreign banks that had invested in the U.S. housing marketreported financial loss, which led to the spread of the financialcrisis to other parts of the world. This culminated in significanterosion of the strength of the banking sector, a decline in theinternational trade, and losses in securities between 2008 and 2009(Briggo,Torresetti, &amp Pallavicinni, 2010).

3.2.3Relaxed credit conditions

Priorto the occurrence of the financial crisis, financial institutionswere doing all they could to increase their market share andfinancial returns. This could be achieved by reducing the interestrates and marketing their products to the subprime customers. Thiswas the major cause of the decline in the interest rate from 6.5 % in2000 to 1 % in the year 2003 (Chakrabortty,2011).The rapid decrease in the rate of interest increased the demand forvarious financial assets. However, the United States needed an inflowof foreign currency to address the deficit in its domestic currentaccount. The foreign funds were provided by foreign governments inexchange for treasury bonds (Chakrabortty,2011).However, the monetary interventions were not sustainable and thecrisis got out of hand.

3.2.4Predatory lending

Thefinancial institutions enticed credit unworthy borrowers, which ledthem into risky lending. This is perceived as part of the Wall Streetgreed where the financial institutions marketed their loans at a lowrate, but ended up charging the customers higher interest rates(Briggo,Torresetti, &amp Pallavicinni, 2010). This was achieved by chargingthe enticed customers the adjustable interest rate where the actualinterest charged would be higher than the interest rate put in theadverts. Consequently, many borrowers ended-up with negativeamortization, which one could only notice once the transaction wasover. (Briggo, Torresetti, &amp Pallavicinni, 2010).

3.2.5Deregulation Thegovernment of the United States seeks to enhance the strength of thefinancial system through deregulation. This implies that thegovernment involvement in the operations of existing financialinstitutions is kept at minim levels. During the period in which thehousing prices were soaring, the financial institutions were temptedto take advantage of these deregulations and bypass different rulesoutlined by the financial sector framework. Financial institutionsrushed for the real estate lending to risky clients, but thegovernment had no control over such practices (Briggo,2010).

3.2.6The effect of overleveraging

Thefinancial institutions succeeded in attracting a large number ofborrowers shortly before the occurrence of the financial crisis,which made them highly leveraged. During this period, differentfinancial instruments (such as securitized balance sheet) were usedto reduce the capacity of regulators and creditors to notice thedegree of financial risks (Simkovic).This subjected the financial institutions to the risk of bankruptcyand collapsing since they could not manage the large number of baddebts that were a surprise to them (Briggo,2010).

3.2.7Financial innovations

Thehousing bubble created an opportunity for financial institutions tocome up with new products that would address the specific needs(owning houses) of their clients. Some of the new innovations includethe use of securities backed on mortgages, mortgages with adjustablerates, collateralized debts, and default swaps all of whichcontributed towards the occurrence of the financial crisis (Briggo,Torresetti, &amp Pallavicinni, 2010). Most of these innovations werestrategies devised by the financial institutions to avoid theregulation. However, the key players in the financial sector failedto perceive the impact of their innovations on the national and theglobal economy, which resulted in financial losses (Briggo,Torresetti, &amp Pallavicinni, 2010).

3.2.8Incorrect pricing of risk

Lendersdo risk pricing in order to compensate themselves for accepting ahigher risk, which is assessed in terms of premiums. Due to theeffect of deregulation, banks failed to give the correct disclosureof their financial risk because they priced their risks incorrectly.This resulted in the overgrowth of the mortgage sector above thenormal rate, thus exacerbating the crisis beyond what would havehappened if the banks would have disclosed their risks correctly(Briggo,Torresetti, &amp Pallavicinni, 2010).In addition, the economic models used to assess the risk showed thatthe risk level was less than it actually was, gave room for the banksto continue lending to credit unworthy clients.

3.2.9The impact of the shadow banking

Althoughit has been widely believed that the banking sector had the greatestresponsibility in the occurrence of the financial crisis, the shadowsystem financed the majority of the mortgages with the highest risk.In addition, the stiff competition caused by this system on theformal banking sector pressured banks to also engage in riskierventures and relax their lending standards(Walker,2010).

3.3Increase in prices of different commodities

Thespeculation that cash flow from the housing sector and other economicactivities would increase resulted in a sharp increase in prices ofnearly all commodities. However, this became evident shortly afterthe bursting of the housing bubble. For example, oil prices increasedafter the housing bubble, which suppressed economies of the oilimporting countries (Diya, 2008). Therefore, instability of oilprices is one of the major causes of the financial crisis. However,the increase in oil prices was in favor of the Arab countries thatwhose economy is mainly support by the sale of petroleum products.This is the major explanation of the capacity of the Arab countriesto survive the financial crisis that affected many economies thatwere closely linked to the west.

3.4Effect of the systemic crisis

Systemiccrisis is another version of explaining the cause of the financialcrisis. This school of thought holds that the occurrence of thefinancial crisis in the year 2008 was a just a symptom of capitalism.This idea is based on the fact that GDP has been decreasing in thewestern economies since the 1970s, which has resulted in surpluscapital that does not have a profitable investment (Simkovic,2009).Consequently, directing the surplus capital into the financial sectorwas perceived to be more profitable than capital ventures, and thiscontributed towards the recurrence of credit bubbles. Moreover, thedebt dynamic as well as the demand gap deficit was mainly caused bydiffering growth in productivity and revenue. In addition, the rapidgrowth in the technology sector is one of the underlying causes ofthe crisis. Moreover, stagnant compensation rates for laborers forcedthem to go for loans to meet their basic needs, but they had nosufficient capacity to service those loans (Diya,2008).In overall, inequalities in the growth rate of capitalism are one ofthe key factors that support the systemic concept that gives analternative explanation for the occurrence of the financial crisis.

3.6The Stock market

Thestock market of the United States was affected for a short durationcompared to other economic sectors. Its decline began in 2007,increased in 2008, but later started recovering in the early part ofthe year 2011 (Diya,2008).

3.7Financial institutions

Thefinancial institutions in the United States made the biggestcontribution towards the occurrence of the financial crisis. The U.S.banks were stricken the hardest where most of them were at the riskof bankruptcy. According to Briggo,Torresetti &amp Pallavicinni (2010) the losses suffered by banks inthe U.S. and in the European market between 2007 and 2009 amounted to$ 1 trillion. The same report indicated that banks in the UnitedStates and Europe have only managed to recover 60 % and 40 % of theirlosses respectively. Initially, the crisis affected companiesoperating in the housing sector, but the effect trickled down to thefinancial institutions towards the end of the year 2008 (Diya, 2008).Most of these financial institutions either failed or were taken overby the government to avoid the complete damage of the financialsector. At this point both commercial banks and the shadow systemwere suffering severely from the increasing in the number of baddebts to an extent that most of the commercial banks in the UnitedStates could not even afford the operating costs. This was the mainreason for the government’s intervention through bailouts, whichwas done to rescue the U.S. financial system and employmentopportunities.

3.8Shadowbanking

Thehousing bubble inflate the demand for funds beyond the amount thatthe conventional banks were able to provide. This created anopportunity for the shadow bakers to flourish and start competingwith established institutions in spite of the fact that the shadowsystem was less regulated by the government (Briggo,Torresetti&amp Pallavicinni,2008). However, shadow bankers gave credits with minimum evaluationof the borrowers’ capacity to service the loans, which resulted inthe increase in the number of bad debts within the sector.Consequently, the shadow credit system was the first to fall,followed by the conventional banking system. During the early stagesof the financial crisis commercial banks raised their lendingstandards, while the majority of the shadow bankers collapsed. Thisreduced the amount of funds that was available for borrowers. At thispoint, the significance of the shadow banking became evidentfollowing the shakeup of the U.S. financial system once most of theshadow banking services ware withdrawn following the collapsing ofthe shadow banks.

3.9Financial crisis and the Muslim World

Althoughthe financial crisis affected nearly all parts of the world, themajority of the Arab countries were cushioned against the impacts ofthe crisis. A study by the World Bank indicated that the Arabcountries had a strong balance of payment and alternative sources offunds, including the sale of petroleum products (Simkovic, 2009).Consequently, the economies of these countries were strong and couldnot be damaged by the crisis. However, the decline in oil prices inthe world market threatened economies of the Arab countries since oilis the key determinant of their economic progress. In addition, theArab world is also likely to be affected by continuous decline in theoil prices and trickling down of the crisis in such an interconnectedworld (Diya,2008).These countries will be required to draw funds from their reserve andwill eventually suffer from the crisis in the long run. However, thepossibility of the Arabic countries being affected by the crisis willdepend on changes in oil prices in the world market.

4.0Chapter 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 dollar trillion marks. The reasonbehind this progressive swell in Islamic financial products is due tothe increased 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 crises, the stock markets were swellingwith virtual derivative wealth, as much as 5 times 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 translate 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.

Gamblingis prohibited in Islamic practice, whether directly through literalgames of chance, or disguised in legitimate trade activities. Theparticular element of gambling prohibited under Islamic law is theunfair or unjustified transfer of risk. This obviously prohibits thetrade in risk itself, as is the underlying element in popular marketcommodities such as Collateralized Debt Obligations (CDOs) and CreditDefault Swaps (CDSs). These products were at the frontline of theglobal financial crisis, and could well be the sole reason so muchwealth was lost. Collateralized Debt Obligations (CDOs) were groupsof loans and risks including student loans, mortgages, car loans,home appliance loans, investment loans and other loans, which werebundled together as one loan with the name CDO and sold to investorsall over the world by investment banks, with the promise that highreturns would be gained by the investor whenever premiums on each ofthese loans were delivered. In turn, the investment banks sellingCDOs would insure them with major insurance companies such as AIG,who was supposed to compensate investors whenever each of the CDOssold to them was defaulted and they could not recover theirinvestment. This in itself was transfer or risk. Risk is toleratedunder Islamic finance insofar as its source is justified andunavoidable, and it is distributed equally or proportionately amongeveryone who would benefit from its absence. Investment banks wereselling loans they did not actually have, by acting as brokers ormiddle agents between investors who want return on capital invested,and loan borrowers who were hungry for funds to use and pay later(Arthur,n.d).

Coincidentally,the CDOs were most prevalent when the country was having one of thelowest interest rates set by the Treasury, making it apparent thatcredit was affordable to borrowers. Thus, whenever an investor boughta high return CDO, they were indeed just buying the risk of anotherloanee being unable to meet their debt obligation, and leapingbenefits whenever the borrower managed to pay. Islamic principlesforbid transfer of debt, or buying goods one can’t pay. It isemphasized that one must use money to pay fully for goods or servicesso purchased. 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.

Asit were, the global value of CDOs in the wake of the crisis was morethan five times the total global assets. CDOs, without proper andtimely regulation, are like pyramid schemes where the wealth of themajority is concentrated in a small time and utilized, with thelarger system losing the equivalent of what a few people gain in theshort period before the scheme collapses. Unfortunately for theglobal financial crisis, the companies who lost money rushed to thegovernment for bailout in 2009, and the government immediately signedbailout papers for close to $700 million to protect the companies(Arthur,n.d).Ultimately, the debts incurred due to careless risk appetite werepaid by the tax payer. The Islamic system of finance is clear on thisaspect that no one is allowed to transfer risk due to their ownaction to be paid by another person. Such a system in place wouldhave prevented the global crisis because engagement in risk tradewould not have happened in the first place, and in any case personsengaging in such would have to pay for their mistakes withoutbailout.

TheIslamic model regarding CDOs would eliminate the bulk of them, andensure that all activities that are potentially risk based would beclosely regulated by the government to ensure that they do not gobeyond a pre-set safe threshold where the event of risk occurrence orsystem collapse would not significantly affect the wider economy. Anyform of debt obligations need to be audited by independent expertswho evaluate the best and worst case scenarios, and ensure that anyform of risk transfer is statistically not beyond a safe thresholdeven in the worst case scenario. For instance, in the globalfinancial crisis, even a basic statistical analysis would have shownthat insurance companies were unable to meet compensation demandsarising from insurance of CDOs and CDSs for even a mere 5% totalclaims, 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.

TheUS government had long been in control of financial markets fordecades, but the combined effect of more than three Acts ofparliament written in the last century was thorough deregulation offinancial 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 of 1982,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.

Incontrast, Islamic finance is closely linked to national values ofobjectivity, real value creation as opposed to virtual wealthcreation, risk distribution as opposed to risk transfer, and a moralbasis to trade. It simply calls for a return to the days where thestock markets and banking sectors were closely monitored by thegovernment for the good of investors who put their trust in thebanks. Even though the requirements of an Islamic like model may seemstringent, the rationale behind the tight requirement is the widergood of the investors, the economy and the entire world. Whilecountries do not need to convert their financial system to useIslamic terms, they can copy the ideals based on Islamic finance toenable longevity of growth. It is worth to note that any system willgain more in the long term through regulated operation than through aself-interest based 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.

Thegovernment was not concerned about all the people who had accessedsubprime mortgage backed loans, and did nothing to intervene whenthey became unable to pay their monthly premiums. Instead, banks werequick to declare foreclosures on houses whose premiums were not metin effect making hundreds of thousands of loanees lose theirinvestments and savings once their properties were repossessed byfinancers. The Islamic model of risk distribution would haveintervened to prevent the numerous foreclosures from happening.

Accordingto Shariah compliant banking, mortgage type financing can only happenwhere the bank and the potential home owner are actually partners,not bank and borrower as in the case of ordinary mortgagearrangements. The banks would have owned all the property that newhomeowners were borrowing money to buy, and then the banks wouldeither lease the property to the customer or jointly own the propertywith the buyer who would then proceed to occupy the house for a rent.Once the tenant paid the monthly rent, the bank and the buyer (who isalso the tenant), would split the rent in proportion to the nature ofinitial financing. The buyer would also run a parallel arrangement togive the bank a premium each month towards full ownership of the homeuntil such a time as the mortgage is fully met. In the otherarrangement where the loanee is a tenant in the house, the bank wouldcontinue to collect rent from the tenant, including a portion of thecost of the house in excess for the purpose of the time value of thebank’s investment, until such a time as the rent premiums have metthe full cost of the home. In the event of a default, the bank wouldlose its investment in the home capital. This would discourage thebank from issuing loans to persons with no demonstrated ability tofully service their loan even in the case of increment of interestrates.

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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