The Global Financial Crisis and the Islamic Finance - Hussein Elasrag - ebook

The world economy is still suffering the crisis, considered the most severe since the Great Depression, where economic downturn at historic magnitude and many countries across the globe, irrespective of their development level, are still under strain dealing with this crisis.This book tries to note the main causes and the impacts of the current financial and economic crisis. In addition to discuss the belief that the Islamic Finance and its prospective is a viable alternative to the ailing global financial system

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Hussein Elasrag

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I. Introduction

II. Fundamentals of the Islamic Finance

III. Nature of the Global Financial and Economic Crisis

IV. Islamic Finance and the Global Crisis

V. The Global Financial Crisis: Lessons From and for Islamic Finance


I. Introduction

The world economy is still suffering the crisis, considered the most severe since the Great Depression, where economic downturn at historic magnitude and many countries across the globe, irrespective of their development level, are still under strain dealing with this crisis.

The severe global crisis that has spilled from the financial sector to the real economy, including international trade in manufactures, commodities and services. The onset of the present crisis can be traced back to July 2007 with the liquidity crisis due to the loss of confidence in the mortgage credit markets in the United States. At first, there was uncertainty about the possible spillovers to the rest of the economy, and there was also discussion about the risks of contagion and decoupling, that is to say, the capacity of other countries – especially developing countries – to isolate themselves from the problems originating in the United States (which is the largest market for many countries). The hope was that the crisis would be restricted to financial markets, with few repercussions on the real economy and the rest of the world. This hope was shattered in September 2008 as the crisis entered an acute phase, with strong downward fluctuations in the stock markets, substantially reduced rates of economic growth, volatile exchange rates, and squeezes in demand and consumption, leading to falls in industrial production and decreasing flows of international trade and FDI, and causing impacts on related areas such as transfer of technology. The crisis has also been accompanied by increases in unemployment, with concomitant declining incomes and demand.

The severity of the current crisis has led to the evaluation of the foundations of the capitalist financial system and the search for ideas and solutions. In addition, reflects problems that go beyond the conduct of monetary policy and regulation of the financial sector. It also involves deeper inadequacies in areas such as corporate governance and competition policies. Many of these failings, in turn, have been supported by a flawed understanding of the functioning of markets, which also contributed to the recent drive towards financial deregulation. These views have been the basis for the design of policies advocated by some of the international economic institutions, and for much of the architecture of globalization.

Nobel Prize Winner, French economist Maurice Allais believes that the way out of such crises is best achieved through structural reforms through, adjusting the rate of interest to 0% and revising the tax rate to about 2%. Islamic economists belief that this is the core elements of Islamic economics. Moreover, they contend that Islamic Finance has an alternative that would prevent the recurrence of a similar crisis. Wherever the Islamic Finance is the only example of a financial system directly based on the ethical precepts of a major religion, providing not only investment guidelines but also a set of unique investment and financing products.” Islamic Finance is based on Shari’ah, the Islamic law that provides guidelines for multiple aspects of Muslim life, including religion, politics, economics, banking,business and aspects of the legal system What Shari’ah compliant financing (SCF) seeks to do is to shape financial practices and accompanying legal instruments that conform to Islamic law. Major financial principles of Shari’ah include a ban on interest, a ban on uncertainty, adherence to risk-sharing and profit- sharing, promotion of ethical investments that enhance society and do not violate practices banned in the Qur’an and tangible asset- backing.

Money, according to Islamic teachings is a measure of value,not a commodity. Debt is a relationship in which risk and responsibility are shared by all parties to a contract.

Two developments that have been critical to the expansion of Islamic financial markets. In 1998, the so-called “Dow Jones Islamic Indexes fatwa” played a transformative role because it opened the door to a limited degree of “permissible impurity” in financial transactions and institutionalized a notion of cleansing and purification whereby small amounts of impermissible interest income could be cleansed or purified by donation to charity. In turn, this led to a series of equity investment tests that could be used to evaluate potential investments for Shari’ah compliance.

A second critical innovation was the introduction of sukuk – a Shari’ah compliant substitute for bonds – where capital protection is achieved not as a loan but as a binding agreement by the issuer to repurchase certain assets over a period of time.

Sukuk has now become one of the backbones of Islamic capital markets and has enabled the rapid growth of Islamic financial transactions.

The multiple reasons for the growth of the Islamic financial sector in recent years: (1) the flow of funds into Muslim oil-producing states;(2) growing political and social desire in the Muslim world for financial alternatives to banking and investment institutions that have been historically dominated by the West; (3) the spreading credit crisis in global financial markets and the need to access new sources of investment capital; (4) the growth of sovereign wealth funds and the desire to have shari’ah compliant instruments through which to invest them; and, (5) the rapidly accelerating number of cross-border multi-jurisdictional financial transactions that are possible and required in a globalized world economy Assets held by Muslim investors worldwide now exceed $1.6 trillion, and that amount is expected to grow to $2.7 trillion by 2010. Shari’ah compliant finance has become an accepted and vibrant element in international financial transactions. It offers a fresh opportunity to emphasize the moral and ethical aspects of business and finance that reaches beyond the Arab and Islamic worlds to prompt a reexamination of the core values underlying all global financial transactions – making available the financial resources needed to develop the human capital that will sustain economic and social progress.

While some have proposed that the Islamic Finance serves as a vehicle for recovering from the international financial crisis and The Islamic banking industry may be able to strengthen its position in the international market as investors and companies seek alternate sources of financing. Other economists have argued that Islamic Finance, is a different way of structuring financial dealings; but, it is not a totally different financial system.

This book tries to note the main causes and the impacts of the current financial and economic crisis. In addition to discuss the belief that the Islamic Finance and its prospective is a viable alternative to the ailing global financial system.

II. Fundamentals of the Islamic Finance

A. Islamic Economy

Islam is a comprehensive way of life, which strikes the balance between the spiritual and the material need of human being. One of the important aspects in human life is the need for a comprehensive system in order to govern their life and to ensure all the needs are catered adequately including the material needs such as the financial management. This aspect of life is closely related to the fast growing industry in the world nowadays, which is the Islamic financial services industry.

An Islamic economy is a market economy guided by moral values. Economic activities are based on principles of cooperation and responsibility. Cooperation means that an economic exchange shall be beneficial to both parties involved. Transactions in which one party wins at the expense of the other are not permissible in Islam. Thus, monopolistic dealings, usury, and exploitation are prohibited. Transactions that allow both parties to win are permissible, and these include most types of activities needed for economic prosperity .Performance-based arrangements, like profit sharing or partnership, represent the most cooperative form of beneficial agreements, and thus are highly encouraged in Islam.

Responsibility means that each individual is entitled for reward or return based on his effort and contribution. Thus gambling and lotteries are not permissible. Gambling allows an individual to gain based on pure luck, not on merit or effort. It shifts wealth blindly among participants leading to improper distribution of wealth. Gambling is a clear form of a zero-sum game where one party wins only if the other loses, and thus causes hatred and enmity among participants. A society where lotteries or gambling like activities prevail is a zero-sum society, where the winner takes all, and the rest is doomed to fail.

B. Islamic Economics

Islamic economics is a framework for studying economic activities that allow mutual benefit of exchange to be realized. It provides proper tools and techniques for evaluating economic decisions, showing when and how to achieve win/win outcomes and avoid win/lose or lose/lose ones. Islamic economics is based on the principle that Allah the Almighty created this world with plenty of resources that satisfy the needs of everyone. Thus one person's success is not necessarily achieved at the expense or exclusion of the success of others. This "win/win" framework leads to better economic behavior and performance, and thus promises better future for mankind. Islamic Banks are financial institutions established according to principles of Islamic Economics. They provide finance and financial services in a manner leading to mutual benefit. Although finance activities are deeply rooted in Islamic history, formal Islamic banking is a recent phenomenon, whereby the first Islamic bank was established around 1963.

C. The Islamic Finance system

One of the most important objectives of Islam is to realize greater justice in human society. According to the Qur’an all the messengers of God were sent to promote justice and any society where there is no justice will ultimately head towards decline and destruction. One of the essential requisites for ensuring justice is a set of rules or moral values, which everyone accepts and complies with faithfully. The financial system may be able to promote justice if, in addition to being strong and stable, it satisfies at least two conditions. One of these is that the financier should also share in the risk so as not to shift the entire burden of losses to the entrepreneur or the borrower, and the other is that an equitable share of the society’s financial resources becomes available to even the poor on affordable terms in keeping with their ability to repay so as to enable them to realize their dream of owning their own homes, pursuing higher education and vocational training, and establishing their own micro enterprises.

To fulfill the first condition of justice, Islam requires both the financier and the entrepreneur to equitably share the profit as well as the loss. For this purpose, one of the basic principles of Islamic Finance is: “No risk, no gain.” This should help introduce greater discipline into the financial system by motivating financial institutions to assess the risks more carefully and to effectively monitor the use of funds by borrowers. The double assessment of risks by both the financier and the entrepreneur should help inject greater discipline into the system, and go a long way in not only increasing efficiency in the use of resources but also reducing excessive lending.

Islamic Finance is based on shariah, an Arabic term that is often translated into “Islamic law”. Shariah provides guidelines for aspects of Muslim life, including religion, politics, economics, banking , business, and law. Shariah-compliant financing (SCF) constitutes financial practices that conform to Islamic law.

Islamic Finance was practiced predominantly in the Muslim world throughout the Middle Ages, fostering trade and business activities with the development of credit. In Spain and the Mediterranean and Baltic states, Islamic merchants became indispensable middlemen for trading activities. In fact, many concepts, techniques, and instruments of Islamic Finance were later adopted by European financiers and businessmen.

In contrast, the term “Islamic financial system” is relatively new, appearing only in the mid-1980s. In fact, all the earlier references to commercial or mercantile activities conforming to Islamic principles were made under the umbrella of either “interest free” or “Islamic” banking. However, describing the Islamic financial system simply as “interest-free” does not provide a true picture of the system as a whole. Undoubtedly, prohibiting the receipt and payment of interest is the nucleus of the system, but it is supported by other principles of Islamic doctrine advocating risk sharing, individuals’ rights and duties, property rights, and the sanctity of contracts.

Similarly, the Islamic financial system is not limited to banking but covers capital formation, capital markets, and all types of financial intermediation. Interpreting the system as “interest free” tends to create confusion. The philosophical foundation of an Islamic financial system goes beyond the interaction of factors of production and economic behavior. Whereas the conventional financial system focuses primarily on the economic and financial aspects of transactions, the Islamic system places equal emphasis on the ethical, moral, social, and religious dimensions, to enhance equality and fairness for the good of society as a whole. The system can be fully appreciated only in the context of Islam’s teachings on the work ethic, wealth distribution, social and economic justice, and the role of the state.

The Islamic financial system is founded on the absolute prohibition of the payment or receipt of any predetermined, guaranteed rate of return. This closes the door to the concept of interest and precludes the use of debt-based instruments. The system encourages risk- sharing, promotes entrepreneurship, discourages speculative behavior, and emphasizes the sanctity of contracts.