Economy, Islam, Islamic Finance
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Islamic Finance and the Global Financial Crisis


By Bilal Rasul

Executive Summary

 

The growth of Islamic financial institutions (IFIs) has been steady but the full potential for deposit-raising remains untapped.

The resilience of IFIs is a direct consequence of transactions being backed by real assets and prescribed financing contracts/agreements.

Disparity between the creation of wealth and underlying real assets is countered through socially and ethically responsible investments propagated by Islamic finance.

The report of the IFSB–IRTI Task Force on Islamic Finance and Global Financial Stability gives recommendations for keeping vigilant and creating global financial stability through IFIs.

The participatory/risk-sharing nature of Islamic finance is the mainstay of the system.

The projection and promotion of Islamic finance philosophy is the key to success.

Emphasis should be on the fiduciary responsibility of IFIs to market products that are authentic (shariahcompliant) so that wealth and the distribution of profits is equitable.

Islamic Finance

Islamic finance is a safe financial doctrine that promises justice and equity. The theme of Islamic finance is popular among those economies that are either interested in following the shariah tenets or are exploring alternative investment opportunities that have a sound basis and a promising potential.

The principles of Islamic finance fundamentally uphold the corporate governance and social responsibility philosophies: that is, accountability, transparency, and equitable distribution of wealth. They are derived from the shariah and the financial laws enabled by the Qur’an. The Qur’an, a complete code of life, is not just for the believers or for Muslims; it is for all mankind (linnaas):

“The month of Ramadan in which the Qur’an was revealed, a guidance for mankind, [a Book of] clear proofs of guidance and the criterion [distinguishing right from wrong]…” Sura Al-Baqarah, ayat 185. (English translation by the Nawawi Foundation, Chicago/Ibn Khaldun Foundation, London).

The stipulations of the Qur’an pertaining to the economic and financial system, too, are for the benefit of all mankind. Adherence to this conduct may not necessarily mean adhering to the faith—a misconception that needs to be addressed in the most benign manner.

Islamic finance is a subject that has reached out to a reasonable number of Muslims, as well as non-Muslims and financial planners. It is now accepted as an international form of financial intermediation. The growth of the industry, 20% annually, 1 has been the swiftest seen by any industry in the last few years. The innovation and product development have been dynamic.

In order to exploit the versatility of the corporate sector, an appropriate strategy is required to reveal the window of opportunity that exists for investors which, undoubtedly, would also launch Islamic finance to larger proportions. The practitioners and scholars of Islamic finance are expected to devise an unprejudiced approach for the purpose. Under the auspices of the Islamic Development Bank (IDB), the Task Force on Islamic Finance and Global Financial Stability was formed in October 2008, on the recommendation of the Forum of the Global Financial Crisis and its Impact on the Islamic Financial Industry, organized by the IDB Group. The Task Force was mandated to: (1) examine the conceptual aspects of Islamic finance and its role in enhancing financial stability; (2) conduct a stocktaking of the state of the Islamic financial services industry following the global financial crisis; and (3) examine the financial architecture of the Islamic financial industry amid the more challenging post-crisis environment.2 Since then the Task Force has thoroughly examined these areas and documented them in a report submitted to them by the three working groups. The report is a public document and can be accessed for a better understanding of the current stability issues that Islamic finance addresses, the state of the Islamic financial industry, and the challenges that lie ahead.

The events transpiring in the last two years leave little doubt that Islamic finance is the way forward and that the discipline should be explored. The role of the IFIs and Islamic regulatory organizations is critical in promoting an ethics-based financial system to provide the solution for the ailing conventional financial system.

Resilience through the Crisis

The resilience of the Islamic financial system has been put to the test at the evolutionary stage of its life.

The incidence of default and financial instability in IFIs was significantly reduced due to the nature of Islamic finance, which is manifested in limited debt leverage, risk and profit sharing, and financial transactions backed by real assets, coupled with legislative restrictions on derivative-like products. Written contracts that emphasize the possession and ownership of real assets are a fundamental source of credibility for transactions and provide disclosure and transparency for investors to shariah standards. “The Islamic financial system is driven by trade and production and is intimately linked to the real sector (‘Main Street’ and not ‘Wall Street’).”

Regulatory oversight, absence of governance, and pitiable rating structures failed the conventional financial system. Lapses in prudential standards and risk mitigating factors added to the tribulations. The hedging instruments that were designed to absorb the risk ended up manufacturing risk. By and large, however, the IFIs remained resilient.

Extract from Ernst & Young Report

Market capitalization of the top 10 conventional banks declined by 42.8%, in contrast to the 8.5% decline of that of Islamic banks between 2006 and 2009.

The profits of conventional banks fell from US$116 billion in 2006 to a net loss of US$42 billion in 2008. By comparison, Islamic banks’ net profits increased 9% during the same period, from US$4.2 billion to US$4.6 billion. No Islamic bank suffered a loss in 2008.

The total assets of conventional banks grew by 36% to US$17.4 trillion, whereas assets of the Islamic banks grew by 55% from US$94 billion to US$147 billion between 2006 and 2008. The growth in total equity during this period was 24% and 36% for conventional and Islamic banks, respectively.

Conventional banks’ leverage ratio (assets/equity) was 16.6 times in 2006, which increased further to 18.2 times in 2008. This was nearly three times the leverage ratio of Islamic banks, which was 5.8 times in 2006 and 6.6 times in 2008.

Five of the top 10 conventional banks received government financial assistance to the extent of US$163 billion in aggregate, while only one IFI required government assistance to restructure. No Islamic bank needed any support from government for bailout.

(From the “Report of the Task Force on Islamic Finance and Global Financial Stability,” Ernst & Young,

2009.)

Is Islamic Finance a Clear Winner?

The bailout of international financial institutions by way of acquisitions by the government, capital injection, and liquidity injection is unprecedented. In the new global financial and economic scenario IFIs may have survived the 2008–09 financial crisis, but whether they have capitalized on the remnants of the defunct capitalist financial system is a question that needs to be probed.

Is it a foregone conclusion that Islamic finance has appeared as the panacea to the collapsed global financial system? Theoretically, the answer is in the affirmative, but realistically and practically, the size of the industry suggests otherwise. A trillion dollar industry though it may be, the asset base of the IFIs figures minutely against the gargantuan conventional financial industry. It would be naive to think that the IFIs survived the financial crisis due to their authentic product lines, good governance, and regulatory frameworks. Systematic risks such as exchange rate risk, market risk, and liquidity risk are externalities that cannot be isolated from IFIs and have a spillover effect, and must be managed by them.

 

Nevertheless, the Islamic financial paradigm may be the long-term solution. “The solution lies in disciplining the creation of money, limiting the self-interest with social aspects and the business ethics, transforming the corrupt financial system to make it free of exploitation and games of chance and thus enabling mankind to optimally use the resources for benefits at a larger scale.”

Post-Crisis Relaunching of Islamic Finance

While the conventional banking and finance industry recuperates from the exigencies of the global financial crisis, this is the opportune time for Islamic finance to prove its competitiveness and enhance its profile. The pull-factor must be rediscovered and employed to attract investors and borrowers toward IFIs to service their financial requirements and avoid the risk-sharing, highly complex hedging investment opportunities offered by the conventional banking institutions.

Researchers and scholars of Islamic finance are endeavoring to create products that are equitable and attractive. However, the discord in transactional issues presented by the varied interpretations of the various schools of thought prevents this system from evolving and being effectively marketed. It must be truly understood and implemented in substance that adoption of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) standards is a precursor to claiming shariah-compliant status. This cardinal principle, in itself, is the key for the harmonization issue.

The Islamic Financial Services Board (IFSB), being the international Islamic financial regulator, also shoulders the responsibility for playing the lead role in marketing and establishing credibility for Islamic finance. International summits and conferences are consistently held around the financial centers of the world to promote and enhance the image of Islamic finance as an ethical and stable financial system. While awareness creation may no longer be the need of the hour, what is required are measures to incentivize IFIs at an industry-wide level: for example, the provision of corporate tax relief to IFIs; capital gains tax exemptions on shariah-compliant securities; withholding of tax exemptions on dividends of shariah-complaint companies; etc. These incentives require the patronization of those governments interested in adopting Islamic finance. Memoranda of Understanding should be inked through the regulatory agencies acting as representatives of their respective countries on the Islamic Financial Services Board (IFSB).

Case Study

Camouflage

A commonplace apprehension among the general public toward IFIs, and Islamic finance in general, is the authenticity issue. This is due to the mimicking or camouflaging of conventional products by the IFI. Although some mimicking may be justified, products need to be totally aligned to the shariah framework that regulates them.

The worker vs his/her tool dilemma presents itself here again, where the tool is the Islamic finance philosophy, which lays down the roadmap for just and equitable distribution of wealth, and the worker is the IFI manager. It is the workman who has to reposition his or her attitude and niyah (intent) toward achieving the prescribed goal of Islamic finance. Highlighting and redefining the fiduciary responsibility of the IFI is critical. The fiduciary responsibility adds another component over and above the regular role of the corporate manager—that is, accountability and subscription to the prescriptions of the shariah. Dubious products marketed by IFIs undermine the credibility of the system. Exploitative and unjust products that disguise

riba (usury), gharar (uncertainty), and maysir (gambling) need to be identified, and the shariah boards must censure those who promote them. The shariah boards also need to be regulated by the overseeing regulatory authority to ensure that they are not simply rubberstamping products.

The sukuk (Islamic bonds) issuances around the world, now a popular Islamic financial product, are also not devoid of structural issues. Similarly, tawarruq (reverse murabahah or monetization), wherein a sale is made for deferred payment, has been held as impermissible by the OIC Fiqh Academy.

The Way Forward

The lessons for IFIs and Islamic financial markets are clear. If financial stability is to be achieved, the separation of risk from the real asset, as embodied in the conventional system, needs to be countered.

Adherence to the risk-sharing philosophy preached by Islamic finance needs to be marketed, and the Islamic infrastructure has to place clear and unambiguous restrictions on questionable transactions. The Task Force has recommended that an Islamic Financial Stability Forum (IFSF) be established to serve as a platform for the deliberation of issues relevant to the ensuring of financial stability in the Islamic financial system.

To grow, adoption of the best practices and international standards prescribed for IFIs is a priority. The intrinsic principles of Islamic finance ensure that the allocation of resources is efficient and equitable, which inexorably will prevent exposure to the market shocks that have afflicted the conventional banking and finance sector. Islamic finance is rationally the next dimension of the financial world.

This entry was posted in: Economy, Islam, Islamic Finance

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Vision 21 is Pakistan based non-profit, non- party Socio-Political organisation. We work through research and advocacy for developing and improving Human Capital, by focusing on Poverty and Misery Alleviation, Rights Awareness, Human Dignity, Women empowerment and Justice as a right and obligation. We act to promote and actively seek Human well-being and happiness by working side by side with the deprived and have-nots.

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