Would Islamic finance have prevented the global financial crisis?
I think Mohammed Amin does a fantastic job in explaining the “global credit crisis.” He’s fast and to the point and very easy to follow. I think this alone makes this post worth a read.
definition: Islamic Banking – refers to a system of banking or banking activity that is consistent with the principles of Islamic law (Sharia) and its practical application through the development of Islamic economics.
background: Islamic banking has been around for a long time and has been mostly limited to Muslim states that practice it for religious reasons. More recently, “Islamic Banks” have been introduced to Europe, India and the U.K. You don’t have to be a Muslim to own, work at, or do business with a “Islamic Bank.” The religious aspect is dropped at most and replaced with simple guidelines and ethics.
but is this practicing or condoning the Islamic faith? I don’t look at from a religious prospective. My agnostic ambivalence aside, the Muslims inherited their “anti usury” beliefs from their Judea Christian roots.
Global Perspective on Islamic Banking & Insurance
To address this question systematically, one needs to consider the following:
- What exactly is the global financial crisis?
- What caused it?
- How does Islamic finance differ from conventional finance?
- Would the differences between Islamic finance and conventional finance have averted the crisis?
These are complex issues and this short article can only provide signposts for further study.
1) What is the global financial crisis?
Diagram 1 shows the difference between Eurodollar LIBOR (the London Interbank Offered Rate at which prime banks lend to each other) and the yield on US Treasury securities. As the US government can print dollars and has never defaulted, its dollar-denominated liabilities are regarded as risk-free, so LIBOR always exceeds the Treasuries’ yield. The spread between them (called the TED spread) has typically been under one per cent, and for most of the last decade was under 0.5 per cent. However it spiked in mid-2007 to nearly 2.5 per cent, remained volatile and in late 2008 soared to over 4.5 per cent. What was happening?
Diagram 2 shows the International Monetary Fund’s projections for the period 2007/10 of bank writedowns on assets by region. The US write-down of 8.8 per cent of total assets is enough to wipe out almost all the capital of the US banking system. It is therefore no surprise to see the massive falls in bank share prices illustrated in Diagram 3.
Governments have been forced to support their banking sectors with capital injections. Otherwise their economies faced a perpetual downward spiral: losses reducing banks’ capital, making them less willing to lend, leading to customer bankruptcies resulting in more bank losses.
2) What caused the crisis?
- US sub-prime mortgages
This is a mortgage loan to a borrower with flaws in his or her credit rating, such as a previous bankruptcy. Normally such borrowers need additional collateral for loans and face higher interest rates.
However, several years of strongly rising house prices caused lenders to relax their lending criteria. Loan-to-value ratios rose and low starter-interest rates were introduced (typically for the first two years of the mortgage) to be recouped by higher interest rates for the remaining 28 years of the typical 30 year US mortgage. In many cases the borrowers knew that they could not afford the monthly payments after the initial two-year low interest period expired; they were relying on rising house prices to enable a profit on sale or refinancing. However, US house prices started to fall. Faced with negative equity many US householders simply walked away from their properties.
- Securitisation Over the years, the US mortgage market had moved away from a ‘lend and collect’ model (the bank lends on a mortgage and collect it back over 30 years) to an ‘originate to sell’ model (the bank makes a mortgage loan in order to sell it on.) Originating loans and selling them on means that banks make profits from lending as much as possible, provided that the loans can be sold on; once the loan has been sold the bank is relatively indifferent to its collectibility.
- Complex securitisation structures
As well as securitising original loans, investment bankers developed more complex structures such as CDO2 (collateralised debt obligations squared) illustrated on Diagram 4. Here CDO securities created by Bank 1 and Bank 2 selling their customer loans are purchased by Special Purpose Entity (SPE) 3 which pays for them by issuing CDO securities to investors. As these are CDOs based on other CDOs, they are called CDO2.
The challenge with such complex structures is that it becomes almost impossible to accurately project likely defaults on the original customer loans to the likely defaults on the securities issued by SPE 3. In many cases, complex CDO structures involved some sub-prime mortgages being blended with prime mortgages to boost the yield of the overall package of assets. Accordingly, once defaults started happening in the relatively small sub-prime market, that led to a collapse in the market value of a much larger amount of CDOs.
- Credit derivatives
Under a credit default swap contract (CDS) as shown in Diagram 5, the seller is paid a regular amount each year by the buyer of the CDS. If a credit event occurs in relation to the underlying asset which is referenced by the CDS, the seller pays the buyer for the fall in value of the reference asset. However, the buyer does not need to own the reference asset; in that case the CDS buyer is simply speculating that the reference asset will fall into default.
Until a credit event occurs, the seller of the CDS receives cash each year. Accordingly, to assess its profits, it needs to assess an actuarial liability for the likelihood of paying out under the CDS. If it underestimates the CDS payout risk, it will erroneously report profits each year. Some very large CDS sellers did report large profits, only to find that as credit market conditions changed they faced losses on their CDS contracts large enough to bankrupt them. Accordingly, the US government had to inject capital into the largest US insurance company, American International Group, to save it from bankruptcy.
The existence of CDS contracts also changes the incentives that apply in the capital markets. A CDS purchaser may be in a position to directly influence the solvency of the underlying borrower of the reference asset.
- General over-leveraging
The economies of the UK and US had not suffered a serious recession for many years. In these benign business conditions, companies had gradually increased their gearing, as interest on debt is tax deductible whereas dividends on share capital are not tax deductible. The high gearing was particularly striking in companies owned by private equity firms, which were typically very highly leveraged. If economic conditions worsened, such firms would risk insolvency.
3) How does Islamic finance differ?
As illustrated in Diagram 6, Islamic finance is a strict subset of conventional finance. Everything done in Islamic finance can be done using conventional contracts; the conventional contracting parties need not care whether their contracts are Shari’ah-compliant. Conversely, there are many contracts used in conventional finance which cannot be used in Islamic finance. Most practitioners consider that Islamic finance prohibits:
- Contracts with excessive levels of complexity or uncertainty (gharar);
- Trading of debts at amounts different from face value;
- Short selling;
- Most derivatives including CDS.
Some of the contracts used in Islamic finance have similar economic characteristics to conventional contracts. For example, the customer in a murabaha contract or an ijara contract makes predetermined cash payments, which can be identical in amount and timing to those a conventional customer might pay under an interest-bearing loan or under a conventional leasing contract.
There are three main reasons why Islamic finance would have been less likely to result in the global financial crisis.
a) Prohibited contracts
Certain contracts are simply prohibited in Islamic finance. The prohibition of gharar and of selling things not owned precludes complex contracts such as CDO2 and CDS. Accordingly, many of the contracts that have led to the greatest difficulties would never have been used.
b) Different risk sharing
The Islamic financial system distributes risk differently from conventional finance. While the same aggregate business losses may arise, their different distribution makes the system less likely to ‘seize up’ or result in corporate bankruptcies.
For example, with a conventional bank, as in Diagram 8, liabilities are repayable in full so losses fall exclusively on the banks equity. Accordingly, even a relatively small asset default rate can seriously impair the banks equity and its ability to lend. Conversely, the Islamic bank in Diagram 9 shares losses with the holders of profit-sharing investment accounts. As the equity of the banking system does not bear all of the losses, its ability to continue to lend is less impaired than in the conventional finance scenario.
Similarly, the issuer of a sukuk based on a mudarabah contract, as in Diagram 7, is less exposed to corporate bankruptcy if the business faces a temporary decline than is the issuer of a conventional bond.
c) Requirement for ethical conduct
There are some prescribed situations, such as UK financial services companies dealing with retail customers, where the institution is required to treat customers fairly. Absent at such special cases, the underlying model of conventional finance is ‘caveat emptor’ (let the buyer beware). However Islam imposes on its adherents a requirement for ethical conduct at all times. Accordingly an Islamic bank should not ‘lend’ money to customers if such ‘borrowing’ is not in their best interests. This would for example apply to the provision of Shari’ah-compliant housing finance to sub-prime borrowers who could not afford the cost once any low-cost introductory period had elapsed.
This overarching requirement for ethical conduct may be the most powerful reason why an Islamic financial system is less likely to repeat the global financial crisis, as it protects against some of the behaviors that led to the crisis.